What is Tobin's Q Theory?

The Q Theory is a theory of investment behavior developed by the US economist James Tobin. Commonly referred to as Tobin's Q Theory, the formula is purported to relate the market value of shares issued by a company to the replacement cost associated with the company's assets. In an ideal situation the market value and the replacement cost would be more or less equal, creating a state of equilibrium.

In Tobin's Q Theory, the market value of the existing shares issued by the company is divided by the replacement cost of the share capital, with "Q" representing the resulting figure. According to this economics theory, "Q" should represent at least a value of 1. When the value is more than one, this is an indicator that additional investment is recommended since the profits generated are higher than the cost of using the assets of the firm.

At the same time, this theory also states that any Q value less than one indicates that the assets used by the company are not being recouped. When this is the case, the company may want to consider selling off some assets, since they are not being used to best advantage. The idea is that by selling off assets that are not directly related to profit generation will help to move the company closer to a state of equilibrium.

When Q is found to be one, equilibrium is considered to be present. This means that according to Tobin's Q Theory, the balance between the cost of using assets and the profit generated is equalized. When this is the case, the company does not need to consider making any changes at all. A desirable balance has been achieved and the company will ultimately benefit by maintaining the status quo.

Tobin's Q Theory is generally accepted as being a reliable means of evaluating the market level of a company. Some economists, however, believe that the Q theory is best utilized in conjunction with other economic theories when it comes to evaluating future actions on the part of a company. From this perspective, this theory is understood as being one of several valid indicators that can help owners and management to plan for future action while not necessarily dictating a specific action.