Problems with Tobin’s Q

Tobin’s Q remains the most-used proxy of “investment opportunities” in financial economics.  Economists typically assume that firms face constant returns to scale, in which case marginal Q and average Q are equal.  Average Q is calculated as the ratio of a firms’ market value to the book value of its assets.

Problem #1: Book value is a poor proxy for replacement cost.  What Q really tries to measure is how much additional future cash flow each additional $1 of investment will produce.  Consider two firms whose only asset is a building, and who each have expected discounted future cash flows (market value) of $1 million.  Firm X bought its building 40 years ago for $1,000, while Firm Y bought its building (which is identical to X’s building) last year for $10,000.  If each firm invests another $1,000, what will happen to their market value?

  • Tobin’s Q calculates that Firm X tends to produce $1,000 of market value per dollar of assets, and so it assumes that Firm X’s market value will increase by $1 million (double its current value).  It implicitly assumes that X can get another building for just $1,000.
  • Likewise, Q calculates that Firm Y will only get one-tenth of a new building, so its market value will only rise by $100,000.
  • This is a well-known problem with Q.  Most researchers either ignore it completely, assuming insignificant differences between firms in asset age, or else try to control for industry and age, assuming that all firms of a certain age within a certain industry group have close-to-identical assets.

Problem #2: market value of the firm (not just of the equity)

  • Another well-known problem surfaces in calculating the numerator of Tobin’s Q, or the market value of the firm.  The market value of a public firm’s equity is a simple matter, but the market value of a firm’s debt is more complicated.  Few firms have publicly-traded debt.
  • About the best anybody does is to simply use the book value of the company’s debt and assume that measurement errors are not correlated with anything important.

Problem #3: forward-looking asset prices

  • The numerator of Tobin’s Q includes the market value of a firm’s equity, which is a forward-looking number that is partially based on investor’s expectations regarding the firm’s future investment.
  • This is mostly a problem when attempting to establish a strong link between Tobin’s Q (“investment opportunities”) and actual investment.
  • Consider two otherwise identical firms in separate parts of the country.  Firm L operates in a labor market that is not expected to have any growth in wages in the future, while Firm K operates in a labor market that is expected to have high wage growth.  Investors expect that Firm L will maximize future revenues by only investing (capx) what is needed to replace worn-out machinery.  Investors expect that Firm K will maximize revenues by replacing worn-out machinery and also replacing labor with capital as wages rise relative to rental rates.
  • The firms will differ in their realized and even in their predicted investment, while Tobin’s Q will not necessarily differ between them.

Do stock market liberalizations cause investment booms?

Henry, Peter Blair, 2000, “Do stock market liberalizations cause investment booms?” Journal of Financial Economics 58 (2000), 301-334.

Purpose:  To show that liberalizing a country’s stock market leads to increased private investment.

Motivation:  International asset pricing theory predicts that a stock market liberalization will be accompanied by a rise in the liberalizing country’s equity prices and by increased investment in physical capital.  Prior research has empirically confirmed the first prediction.  This paper investigates the second.

Findings:  In countries that liberalize their equity markets, where the marginal product of capital is high and domestic cost of capital exceeds the world average, private investment significantly and meaningfully rises.

Data/Methods:  This is an event study of liberalization in a sample of 11 emerging-market countries.

  • Determine dates of liberalization by using date of government mandate, date of first country mutual fund, or date of a jump in the IFC’s Investability Index.
  • Obtain private investment data from the World Bank’s STARS database (Socioeconomic Time Series Access and Retrieval).
  • Find stock returns in local currencies (including dividends) in the IFC Global Index, from the IFC’S Emerging Markets Database (EMDB).
  • Regress changes in log investment on dummies for the year of liberalization and the two following.
    • Include calendar year dummies to control for global macroeconomic trends.
  • Regress changes in log investment on stock returns and lagged stock returns.
    • Again include calendar year dummies.
  • Also use real U.S. interest rates and OECD output growth rates to control for world business cycles.
  • Use dummies to control for other simultaneous reforms: macroeconomic stabilization programs, trade liberalizations, privatization programs, and reductions of exchange controls.
  • Also control for domestic fundamentals, such as GDP growth.


  • Market liberalization leads to increased stock prices.
  • Growth in private investment is strongly correlated with changes in stock prices.
  • The correlation is stronger for valuation changes related to liberalization.
  • Private investment increases after liberalization, even after controlling for global cycles.