The most striking thing about Bill Gross’s column this month, about equity valuations, is the first graph, showing the evolution of Tobin’s Q over the past few decades:
Gross explains that Q is the value of the stock market, divided by the replacement cost of net assets:
The basic logic behind “Q” is that capitalism works. If the “Q” is above 1.0, then the market is valuing a company at more than it costs to reproduce it; stock prices should fall. If it is below 1.0, then stocks are undervalued because new businesses can’t be created at as cheap a price as they can be bought in the open market. In the short run, this ratio is volatile as shown below but it tends to be mean reverting, which is critical. As long as capitalism is a going concern, “Q” should mean revert to 1.0. If so, then oh, oh what a “Q”! Today’s Q ratio has almost never been lower and certainly not since WWII, implying extreme undervaluation.
But what exactly is Gross’s graph showing us? According to the legend up the y axis, it’s measuring "MV of Equity/BV of Equity", where MV is market value and BV is book value. But isn’t this just our old friend the price-to-book ratio? And if it is, why is Q so low? Surely the stock market as a whole isn’t trading at a price-to-book ratio of around 0.25.
It turns out that the crucial difference between Q, on the one hand, and price/book, on the other, is the way you value a company’s assets. On a company’s balance sheet, tangible assets are valued at cost. In Tobin’s Q, you don’t want to know what those assets cost, you want to know what their replacement value — their current cost –is.
And where can one find that number? Why the Fed, of course, in its enormous Flow of Funds report. Check out table B.102 in this PDF, which is on page number 103 or the second page of the PDF. In line 2, you can see that the tangible assets of America’s nonfarm nonfinancial companies come to about $15 trillion — that’s what you’d need to spend to build those companies from the ground up. Add in the financial assets and subtract the companies’ liabilities, and you get a net worth (line 32) of about $16 trillion. That’s the denominator in Tobin’s Q.
On the other hand, if you use the cost basis of the assets, the tangible assets are only worth $9 trillion (line 40), and the net worth of the companies is $10 trillion (line 44). That’s the denominator in the price-to-book ratio.
Now I don’t know the total market capitalization of America’s nonfarm, nonfinancial companies — I’m not sure what numerator Gross is using, or what adjustments he’s making for farms and financials. But clearly if you’re dividing by $16 trillion, you’re going to get a significantly smaller number than if you’re dividing by $10 trillion.
Even so, this Q is low. If it’s 0.3, and we ignore the farms and financials for the time being, that would imply a total capitalization of America’s nonfarm nonfinancial companies of less than $5 trillion. And Exxon alone is worth $400 billion. What’s more, even after unleashing this number on us, Gross still doesn’t think stocks are cheap. They’re cheap by the standards of a high-leverage, low-tax world, yes, he says. But that’s not the world we’re entering. Caveat Emptor.