‘How much is my business worth’ is a common question I get.
There are as many ways to value a business as there are consultants willing to charge you for a calculation. Sensible people use a range of tools, all of which in one way or another, seek to quantify future cash flow. That is the only reason someone would buy a business: they can extract more value from the capital deployed buying it, than deploying it in other ways.
Tobin’s Q ratio is one of those common tools that will deliver a number that is worth consideration, along with the many others.
It is a financial metric that compares the market value of a company to the replacement cost of the assets of the company. It helps investors figure out if a company is overvalued, undervalued, or fairly priced.
In a time when the value of a business is significantly influenced by the valuation of intangibles, all those items that deliver value to a buyer, but which do not make their way into the financial statements, you also need to consider how these will be valued, which is an entirely separate exercise, and by far, the most contentious.
The simplest way of thinking about the Q ratio is to consider:
- Market value is what investors think the company is worth—this is the company’s stock price multiplied by the number of shares. That applies for a publicly traded business. It is much harder to calculate when there is nowhere that shares can be traded easily. In that case, the judgement becomes more subjective, taking the place of the sentiments of the market that determines the value of a publicly traded share.
- Replacement cost is what it would cost to replace the company’s assets. How much it would take to rebuild or replace everything the company owns, including the intangibles. It is relatively easy to get a valuation of the physical assets, but much harder to calculate the value of a brand, the experience in your employees heads, the strategic position in a market you hold, and the list of customers you have.
A ‘Q value’ greater than 1 means that the company’s market value is higher than the cost of replacing its assets. This could mean investors are optimistic about the company’s future growth, or the company might be overvalued.
A ‘Q value’ less than one means the company’s value is lower than the replacement cost of its assets. This could mean the company is undervalued, or investors don’t think the company will perform well in the future.
Obviously, when the Q value is 1, the market value is in balance with the replacement cost of the assets, including intangibles.
The really challenging bit is putting a value on the intangibles. For that you need deep marketing experience, domain knowledge, and wisdom.
