Q Continuum
Via Felix Salmon, Bill Gross writes about the all-powerful Q:
The basic logic behind “Q” is that capitalism works. If the “Q” is above 1.0, then the market is valuing a company at more than it costs to reproduce it; stock prices should fall. If it is below 1.0, then stocks are undervalued because new businesses can’t be created at as cheap a price as they can be bought in the open market. In the short run, this ratio is volatile as shown below but it tends to be mean reverting, which is critical. As long as capitalism is a going concern, “Q” should mean revert to 1.0. If so, then oh, oh what a “Q”! Today’s Q ratio has almost never been lower and certainly not since WWII, implying extreme undervaluation.
Maybe I’m an idiot, but I feel like this explanation can’t survive a cursory glance at the chart. We’re looking at 56 years of data and the ratio has been below 1.0 for something like 46 of them. There’s no reverting to 1.0 here, it looks more like reverting to 0.6 or so by my eyeball.
38 Responses to “Q Continuum”
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December 3rd, 2008 at 8:47 am
Nah. Gross is the idiot. Reproduction cost acts as a cap on value, not as a valuation in and of itself. A business can be perfectly profitable even though reproduction cost would be prohibitive. Valuations above reproduction cost are necessarily irrational and have to fall, but that in no way changes the facts that assets depreciate, inefficiency happens, and dividends are taken, making values below reproduction cost perfectly normal.
December 3rd, 2008 at 8:52 am
I don’t get the line “Today’s Q ratio has almost never been lower…” either. Eyeballing the chart, it was lower during most of the 70’s and 80’s.
December 3rd, 2008 at 8:53 am
There are two sets of data used to come up with this ratio. One for MV of Equity and one for BV of Equity. Felix does a pretty good job explaining where the BV of Equity came from and how it differs from actual P/B ratios (The data is from the FED) but it’s still not clear what data is being used for MV of Equity.
Assuming the FED does a good job estimating the replacement cost of capital the ratio’s mean will still be dependent on what data we use for MV of Equity. According to Felix the FED’s data is based on non-farm equipment. If this data includes capital for more then just publicly traded companies that could push the mean well down below 1.
Despite this the data does seem to be reverting to some mean, which is interesting.
December 3rd, 2008 at 8:57 am
Just what we need. A lecture from Bill Gross on the wonders of capitalism. He is CEO of Pimco, the biggest bond investment firm in the world. He made a huge bet on GSE mortgage backed paper as it plunged. Well it wasn’t much of a bet because he knew when the time came that the government would make explicit the implicit government guarantee on GSE mortgage backed securities (MBS’s)
While this was a smart investment decision and knowing what he knew, that a bailout was certain, he would one might say, bound by his fiduciary responsibility to make that investment. However the point is this has nothing to do with free market capitalism.
The Treasury and taxpayers are going to take a stupendous hit on the GSE paper, and give some of it to Bill Gross. He lobbied for it on TV even. He has about as much right to lecture on correctness free markets as Karl Marx.
December 3rd, 2008 at 9:09 am
Q is a balance sheet measure — the cost to reproduce the firm. It says nothing about the companies future earnings.
Also, some intangible assets are difficult to value — like the value of the brand “coke”.
December 3rd, 2008 at 9:20 am
When investment is to some extent irreversible or costly to reverse, q should be less than 1, not equal to 1. There is a cost to lock-in and you won’t lock in without the prospect of some super-normal returns. You are right and the source pushing q theory is not fully on the ball.
December 3rd, 2008 at 9:23 am
I was curious about the graph at the link showing corporate tax rates, and I wondered if JP Morgan was using official tax rates or tax rates as actually collected.
December 3rd, 2008 at 9:31 am
Hmmm… to my untrained eye, what the longer-term graph DTM links to seems to indicate is that any time Q is consistently over 1, we’re in a bubble and headed for a crash.
But that seems right, given what Tyler said. It should be cheaper and riskier to build a new company from scratch than to go out and buy an old one lock, stock, and barrel; whenever it’s not, something is probably wrong.
December 3rd, 2008 at 9:53 am
That chart is nonsense. It says that stocks have been undervalued since 2004. Really? That chart was moving down even before the down market of the past year. How can that be, since the all time high of the Dow wasn’t much more than a year ago?
December 3rd, 2008 at 9:59 am
I agree with Paul B: That long-term Q graph is scary. It has only two significant spikes over 1.0 and the other one is 1929.
I’d eyeball mean Q on that graph as somewhere around 0.7, for which Tyler’s explanation seems plausible.
It’s interesting that the current Q spike seems to have begun around the time Clinton took office. Why would investors have showed such an excessive preference for investing in existing companies vs. starting new ones during the Clinton Administration? Did P/E spike at the same time?
December 3rd, 2008 at 10:39 am
Isn’t the fact that Q tends to be below 1.0 a demonstration of the equity premium?
December 3rd, 2008 at 11:25 am
December 3rd, 2008 at 12:35 pm
Maybe the 0.4 differential is based on the assumption that a company’s management is clueless, a fair assumption in many industries.
December 3rd, 2008 at 3:08 pm
I’m impressed that all your other commenters understand this graph because I have no idea what MV and BV on the vertical axis mean.
December 3rd, 2008 at 5:59 pm
DTM wrote: “That is certainly true, and it was one of the reasons people gave to justify the high Q-ratios during the dot com bubble (the idea being that the intellectual property of firms was being undervalued).”
There was also a lot of nonsense about ‘network effects’. Because, you know, once you’ve installed Pointcast, all your friends will too, and you’ll never switch.
December 3rd, 2008 at 6:40 pm
Egads! 19 comments before mine and I’m the first one to make note of the Star Trek reference in the title? What’s the matter with you Econ nerds (asked the Sci Fi geek)?
Anyway .. carry on .. don’t mind me.
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