Earlier this year, two law professors at the University of California, Berkeley School of Law took issue with of all things Tobin’s Q. Though named for James Tobin, the idea had been introduced much earlier by several people. Tobin popularized one view of the concept. Robert Bartlett and Frank Partnoy objected to many of the contemporary uses.

To judge firm valuations, Tobin proposed a numerator consisting of the firm or asset’s market price. This would be divided by its replacement cost. The resulting ratio was supposed to tell us something about fair value.

It has been distorted over the years into many different practices. It has become common in law as finance to use the Q ratio as a reductive market-to-book ratio. It is even more common to impute meaning into this simplified construct. Bartlett and Partnoy warn:

Many of the problems arise because regressions that have as their dependent variable a ratio with book value in the denominator are likely to produce biased estimates, due to both omitted assets and time-varying, firm-specific characteristics that can systematically alter a firm’s book value. As a result, the simplistic version of q produces non-classical measurement error in regression specifications that seek to estimate the relationship between firm value and various corporate and regulatory phenomena.

The short version: book value isn’t so straightforward. It is the accounting world’s stand-in for what Tobin was once specifically seeking to measure. Book value isn’t always or exactly replacement cost, though in principle it might seem awfully close.

One standard use for this modern Q ratio is to value the stock market more broadly. Here we use the Federal Reserve’s Z1 estimate for non-financial corporate equities as its numerator, broadly speaking the market value of aggregate businesses in the corporate marketplace. At the denominator we place corporate net worth, obviously non-financial as well and also pulled from Z1.

It’s not exactly book value but again it is close enough to the concept. Or it might seem.

On a big picture level, Tobin’s Q, this version, is meant to judge market valuations of equities keeping in mind tangible value; or what we might call wealth. These supply side concepts pull together various factors such as profits, investing, and, perhaps most of all, opportunities and whether the business sector is taking, or will be able to take, advantage of them.

The market is not the economy and the economy is not the market, my colleague Joe Calhoun always, always, always protests. And that’s absolutely true; but. One should be related in the long run to the other. That’s the point of things like the Q ratio, to judge whether or not there is too much future in the current market given the current economy. Too much extrapolation is dangerous, meaning risky. Joe’s right in that this is a long run rather than short run notion.

The Q ratio is supposed to be mean reverting, that’s its purported value – what are the chances the denominator drives the reversion, or the numerator? 

Put another way; is the market valuing future growth at the expense of present conditions? After all, if the price of an asset is way, way more than its replacement cost you should immediately sell the asset and greedily obtain its substitute. Play the market value for the fool. That wouldn’t say anything good about a company sporting an obscene stock market valuation. 

As you can see above, corporate net worth has been rising rather steadily despite the fact that the US and global economy has fallen way off track. That’s already an unusual situation. It might be a legitimate deviation if US companies were simply faring much better overseas, deriving domestic net worth increasingly from their foreign operations. That’s not the case, as we know from this decade plus global slump.

As equity prices continue to rise precipitously, raw net worth to a large extent has “justified” the market advance. Valuations are still high in historical context, but are stocks being valued artificially even here? The recent connection, or misconnection, with nominal GDP suggests something else is going on.

This is a relatively new phenomenon. Prior to the mid-1990’s, these two different denominators were pretty close in their assessments of equity values. Since the dot-com bust, net worth has disconnected from nominal GDP.

Even when we begin to account for irregularities in corporate net worth, the division remains. In the “modified” Q shown above, we subtract the value of real estate holdings from net worth. Real estate assets in the Z1 data are recorded at market value rather than replacement cost or book value. In that way, one bubble in real estate could theoretically be used to judge another in stocks.

And that’s not what we are really after. Even in situations where valuations might be high, even unusually high, they might be consistent with future developments. If replacement costs are going up for organic reasons of economic growth, then even when valuations are up there they might simply be investors arriving early to a very beneficial trend. After all, the key to value is sustainability.

The probability for increasing net worth rises when the economy is doing well. Therefore, the proxy of nominal GDP in theory should be very consistent with corporate net worth – so long as net worth is being driven by economic factors. This gets us back to the Berkeley law pair, who both note how it’s just not that easy.

In this context, we already have some idea about what it is that has been driving corporate net worth further apart from GDP. In the Z1 data, “miscellaneous” assets have increased since 1995 at an incredible pace. There is in all likelihood a real-world activity driving this (not purely a statistical dislocation).

While earnings contracted during the 2015-16 global downturn, and then took a very long time rebounding, the “value” of miscellaneous assets surged by more than 40%.

The Z1 figures aren’t precise, though we can guess what’s behind the increase. Before stock buybacks became a popular choice for boardroom investment, M&A was all alone at center stage. The merger mania that we still find today began in earnest in the early and middle eighties.

The heyday for them came in the late nineties dot-com bubble, and over the past few years they have made a major comeback both during the same timeframe as the Z1 figures for miscellaneous assets. The Institute for Mergers, Acquisitions, and Alliances (IMAA) notes that there was a huge wave of transactions in the dot-com period, and then another one beginning around 2014. In fact, according to data compiled by the IMAA, in 2017 the number of announced restructurings finally exceeded the record set in 1998.

This year is on pace to nearly equal last year’s total (and exceed it in value).

It suggests that goodwill might be behind the distortion in net worth. When one company buys another above its target’s replacement or book cost, the difference is recorded as an intangible, miscellaneous asset. But this gets us back to the argument over book value distortions. Goodwill is a future asset, not a current one.

If companies are overpaying for acquisitions, then that inflation is being fed back into this version of “book value.” The purpose of the Q ratio is to screen and filter one from the other. This is especially egregious when acquiring firms are leaning heavily on debt finance to undertake the transaction. In that case, credit growth could be distorting what should be instead a fundamental value proposition.

There is, on its face, nothing wrong with companies borrowing. It happens all the time and for legitimate business reasons. But are they doing so in ways that will help increase their future values? An influx of goodwill doesn’t necessarily prevent future success, but it does add another layer of uncertainty; a more inclined slope to risky extrapolation.

High valuations already suggest uncertainty, a lower probability or a longer timeframe (and therefore higher risks) for companies to eventually live up to them. If those high valuations are being further stretched because businesses are paying a lot more for other businesses? Maybe not, but it raises more questions and places even greater emphasis on what’s beyond the horizon. The risks are that much higher.

Adjusting corporate net worth by subtracting miscellaneous assets (which could be an overreaction) puts adjusted corporate net worth much closer to the economic reality for opportunity presented by nominal GDP – especially post-2008.

By this view, it would seem that corporate America has been building for the future by financial engineering – if for no other reason than the pitiful economic circumstances of the last decade. But are they raising or reducing the chances for these financial bets paying off?

The future economy would therefore have to cover both existing valuation mismatches as well as these embedded premiums that corporations have built into their business capacities through M&A as well as share buybacks. Sticking closer to Tobin’s basic idea, unless the economy begins to really accelerate (more like 1984) then it seems more likely they would have been better off building their own asset base rather than hugely overpaying for others.

From here, you can appreciate why there is such emotional investment in a “hawkish” Fed. It’s often said that the biggest risk to stocks is inflation or higher interest rates. Not at all; the biggest risk is actually the flat yield curve where it is now. If the Fed has it all wrong, another forecast error, as these several curves propose, then there is no way to pay off both current valuations as well as those embedded overpayments for assets already purchased far above apparent replacement costs. In other words, not only are investors overpaying for a future that isn’t likely, companies themselves have been doing the very same thing to an even greater extent. 

Net worth is less likely to be, for too large a portion, worth it. Everything has to go right, which suggests valuations are really as high as they appear to be in both the Modified B ratio as well as the other with GDP as the denominator. The world’s future (this is not just a US issue) has been mortgaged on QE paying off. Someday.