E-piphany

Another neat item you can compute from data in the quarterly Z.1 Flow of Funds report is a measure of equity market valuation called Tobin’s Q.

Tobin’s Q was proposed by (surprise!) Nobel Laureate James Tobin around 1970. It simply measures the market value of stocks (or a single company’s stock) compared to the net worth of listed companies (or a single company’s book value).

Warren Buffett has said in the past, with respect to investors in Berkshire-Hathaway, that he would prefer his stock just as fast as the company’s true value, since if it does, then a buyer will participate fully in the company’s fortunes during his holding period without taking value from another investor. It is an adroit observation: if an investor buys below true value and sells above true value, then he has done better than the company itself. That sounds great, but the investor’s gain comes at the expense of the person he sells to, who is buying the company above value and therefore will not fully participate in the company’s fortunes (unless he in turn finds a greater fool). Buffett, as Chairman, would prefer all of his partners to experience the firm’s fortunes on an equal basis. The only way to guarantee this is if the stock always trades at true value.

Tobin’s Q has similar implications: a buyer who buys when Tobin’s Q is below 1.0 (subject to some caveats, which I’ll mention in a second) will probably get no worse than the actual growth of the companies’ fortunes, since eventually prices return to value. On the other hand, a buyer who buys when the Q is quite high has no such guarantee that prices will ever return to a similar level above value; consequently, one wants to avoid buying high Q.

Now, reality intrudes a bit on the theory because accounting standards being what they are, the idea of “corporate net worth” has become somewhat squishy in recent years. And so 1.0 doesn’t have quite the magic one would expect; corporate net worth is probably exaggerated so, over a very long history, the Q Ratio averages around 0.65. Right now, it is 0.91, roughly as overvalued as it was in the middle of 2008.

A nice chart of the Q Ratio, relative to the historical average, is shown below. Here is the link to the page.

Back to the Peak of the Go-Go Sixties

While the stock market is nowhere near as overvalued as it was in 1999, or even at the peak of the echo-bubble a couple of years ago, it is disturbing to me (and not only to me) that equities have never gotten back to ‘bargain’ levels yet. The March lows appeared to be bargain levels (and I admit I was buying late last year although I was too squeamish to add much in 2009Q1) only because of there they had come from.

With economic fortunes (and bank earnings) this variable, I like the Q even better than looking at multiples of 10-year trailing earnings. It probably makes the most sense to look at both of them…and neither is particularly encouraging at present.