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
- If the Q ratio is greater than one, it indicates that the company is earning well and have good returns. It is an indication that if the company goes into liquidationLiquidationLiquidation is the process of winding up a business or a segment of the business by selling off its assets. The amount realized by this is used to pay off the creditors and all other liabilities of the business in a specific order.read more, then also the funds of the investors are safe, and the company’s assets are capable enough to repay all the debts.
- If the ratio is lower than 1, it indicates that the company’s worth is undervalued. A ratio equals to 1 indicates that the company or market is fairly valued.
The formula of Q Ratio
Q Ratio = Market Value of Assets / Replacement Cost of Capital
Where,
- The market value of assets reflects the current market value of all the assets, whether movable or immovable.
- Replacement costReplacement CostReplacement Cost is the capital amount required to replace the current asset with a similar one at the present market rate. Usually, assets replacement occurs when their repair & maintenance charges surge beyond a reasonable level. read more indicates that if assets are sold today, then what will be the value that the company is able to collect if it liquidates.
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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.
- Where the value of the stock market is the value of all the securities listed on the stock market, and corporate net worth is the sum of the net worth of all the companies listed on the stock marketStock MarketStock Market works on the basic principle of matching supply and demand through an auction process where investors are willing to pay a certain amount for an asset, and they are willing to sell off something they have at a specific price.read more.
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 –
- = 50/40
- = 1.25
As the ratio is greater than 1, it indicates that the company is performing well and enjoying the goodwill
Uses
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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
- It is commonly used in the valuation of the company, the valuation of goodwill, etc.
- This ratio is applied by Banks and financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more to know the worth of a potential client.
- It is applied to know the real net worth and standing of the company in the market.
- The market Q Ratio is applied by Foreign or International investors to determine whether the investment will be beneficial or not.
- It is also applied by analysts to analyze the position of a particular company or market at large to estimate future situations.
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.
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