Market Valuation: New Q Ratio Data Released Today June 9, 2011 Special Update
Note from Doug: The latest Z.1 Flow of Funds, data through Q1, was released today at 12 PM EST. The balance sheet data on which Q is calculated have undergone very substantial revisions. I'll post a separate commentary to provide more details, but suffice to say, Q calculations to two decimal points have been modified as far back as Q4 2004. I've updated the commentary and charts below to reflect the Uncle Sam's changes.
The Q Ratio is a popular method of estimating the fair value of the stock market developed by Nobel Laureate James Tobin. It's a fairly simple concept, but laborious to calculate. The Q Ratio is the total price of the market divided by the replacement cost of all its companies. Fortunately, the government does the work of accumulating the data for the calculation. The numbers are supplied in the Federal Reserve Z.1 Flow of Funds Accounts of the United States, which is released quarterly.
The first chart shows Q Ratio from 1900 to the present. I've estimated the ratio since the latest Fed data (through 2011 Q1) based on a combination of the price of VTI, the Vanguard Total Market ETF, and an extrapolation of the Z.1 data itself.
Interpreting the Ratio
The data since 1945 is a simple calculation using data from the Federal Reserve Z.1 Statistical Release, section B.102., Balance Sheet and Reconciliation Tables for Nonfinancial Corporate Business. Specifically it is the ratio of Line 35 (Market Value) divided by Line 32 (Replacement Cost). It might seem logical that fair value would be a 1:1 ratio. But that has not historically been the case. The explanation, according to Smithers & Co. (more about them later) is that "the replacement cost of company assets is overstated. This is because the long-term real return on corporate equity, according to the published data, is only 4.8%, while the long-term real return to investors is around 6.0%. Over the long-term and in equilibrium, the two must be the same."
The average (arithmetic mean) Q Ratio is about 0.71. In the chart below I've adjusted the Q Ratio to an arithmetic mean of 1 (i.e., divided the ratio data points by the average). This gives a more intuitive sense to the numbers. For example, the all-time Q Ratio high at the peak of the Tech Bubble was 1.82 — which suggests that the market price was 158% above the historic average of replacement cost. The all-time lows in 1921, 1932 and 1982 were around 0.30, which is about 57% below replacement cost. That's quite a range.
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