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

  • 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 liquidation, 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,

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.

  • 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 market.

Example

The Book Value of Assets 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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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 goodwill 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 amalgamations, mergers, 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 –