Q Ratio

What is the Q Ratio?

Q Ratio is used to determine the valuation of the company or the market at large in order to know whether it is overvalued or undervalued and is calculated as the ratio of the market value of physical assets of the company and the net worth of the company. This ratio was developed by James Tobin, an expert and Nobel Laureate in economics is used in amalgamations, mergers, and other valuation models to determine the actual worth of the company

The formula of Q Ratio

Q Ratio = Market Value of Assets / Replacement Cost of Capital

Where,

Q-Ratio

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For eg:
Source: Q Ratio (wallstreetmojo.com)

Eventually, the valuers find it difficult to determine the replacement cost of all the assets. Hence the ratio was modified as under:

Q Ratio = Market Value of Equity + Market Value of Liabilities / Book Value of Equity + Market Value of Liabilities.

The formula for the overall market is as under:

Q Ratio = Value of Stock Market / Corporate Net Worth.

Example

The Book Value of AssetsBook Value Of AssetsBook Value of Assets is the asset's value in the books of records of a company or an institution at any given instance. Assets Book Value Formula = Total Value of an Asset – Depreciation – Other Expenses Directly Related to it read more of the company is $ 40 Million, and the company has 5 Million shares outstanding trading at $ 10/ share. Determine the Q ratio and analyze whether the company is earning well and enjoying benefits, or it is undervalued on the basis of your calculations.

Solution

Calculation of Q Ratio can be done as follows –

Q Ratio Example 1
  • = 50/40
  • = 1.25

As the ratio is greater than 1, it indicates that the company is performing well and enjoying the goodwill

Uses

Uses of Q Ratio

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For eg:
Source: Q Ratio (wallstreetmojo.com)

Determine the Value of the Company

It is used to determine the value of the company so as to evaluate whether the securities are overvaluedOvervaluedOvervalued Stocks refer to stocks having more current market value than their real earning potential or the P/E Ratio. Overvaluation of stocks might occur due to illogical decision making or deterioration in a Company’s financial health. read more or undervalued.

Valuation of Company or Goodwill

It is commonly used in the valuation of a company in case of sell or absorption of the company so as to determine the true value of the company. It is also used in determining the value of goodwillValue Of GoodwillGoodwill valuation is the systematic evaluation of the goodwill of the company to be shown in the balance of the company under the head intangible assets and top methods to value include Average Profits Method, Capitalization Method, weighted average profit method and the Super Profits Method.read more as if the ratio is greater than 1; it shows that the company has goodwill, and because of it, the company is earning well.

Used in Amalgamation, Mergers, and De-Mergers

It is useful in amalgamationsAmalgamationsAmalgamation is the consolidation or combination of two or more companies, known as amalgamating companies, usually in the same or similar line of business, to produce a new legal entity, known as the amalgamated company, with the same shareholders, assets, and liabilities.read more, mergersMergersA merger is a voluntary fusion of two existing entities equal in size, operations, and customers deciding to amalgamate to form a new entity, expand its reach into new territories, lower operational costs, increase revenues, and earn greater control over market share.read more, and de-mergers to determine the value of the company to compensate the shareholders on the basis of the valuation and Q Ratio.

  • It is also used by banks so as to approve the loan and to determine the capacity of repayment.
  • It is used by liquidators at times of valuation to analyze the position and worth of the company.
  • It is also used by credit rating agencies to analyze the ratings to be given to the company.

Applications

Advantages

  • Helpful in amalgamation, merger, and other transactions to determine the actual net worth.
  • Helpful in analyzing the benefits of investment.
  • With Q Ratio, the potential of the market can be determined.
  • It is an effective tool for attracting foreign investment.
  • The market volatility can be controlled to the extent with the help of this ratio.

Disadvantages

  • It is calculated on the basis of market value, and the market is always ascertained, i.e., market situations can change positively or negatively at any time.
  • The real potential of the company is ignored while calculating the Q Ratio.
  • Some companies got the under-valuation price due to the calculation method by the market value approach.
  • Sometimes it becomes very difficult to determine the market value because of unique features or self-created assets.

Recommended Articles

This has been a guide to what is Q Ratio and its definition. Here we discuss formula, example, and uses of q ratio along with applications, advantages, and disadvantages. You may learn more about financing from the following articles –