The Misuse of Tobin’s Q

In our paper, The Misuse of Tobin’s Q, which we recently posted to the Social Science Research Network, we examine the common and growing misuse of Tobin’s q as a proxy for firm value within the law and finance literatures.

For several decades, Tobin’s q has been one of the most important concepts in business law and policy for examining how various regulatory and corporate governance provisions affect firm value, and therefore economic welfare. More than three hundred law review articles, including many of the most widely-cited in corporate and securities law, have referenced Tobin’s q as a proxy for firm value, as have hundreds of articles in the most highly-regarded peer-reviewed finance and economics journals. The trend in citations to Tobin’s q is markedly upward, and in 2017 alone, articles in leading law reviews referenced Tobin’s q as a proxy for firm value in analyzing such important topics as how firm value was affected by hedge fund activism, fiduciary duties, staggered boards, and corporate governance.

As originally conceived, Tobin’s q, named for the economist James Tobin, was an important variable in macroeconomic theory; it was defined as the market value of a firm’s assets divided by their replacement value. Within macroeconomics, it was originally viewed as a means to understand corporate investment policy, as a firm having a q greater than 1 should be expected to reinvest until its q returned to 1.

However, outside of macroeconomics—most notably, in law and finance—scholars have used a very different, more simplistic version of q, which we label “Simple q,” as a proxy for firm value. Simple q is essentially a version of the market-to-book ratio: the market value of a firm’s capital divided by its book value. Given the tendency of scholars to estimate firm value using Tobin’s q, Simple q has accordingly become the main dependent variable in statistical tests of the most important questions in business law. How do different countries’ legal regimes influence the value of firms? How are corporate governance indices related to firm value? Is incorporation in Delaware a race to the top or bottom? What is the effect of staggered boards? For decades, scholars have attempted to answer all of these important questions and many others using studies based on Simple q.

Our central point is that the scholarly use of Simple q as a proxy for firm value is fatally flawed. As a general matter, Tobin’s q, in any specification, is not a good proxy for firm value, either in theory or in practice. James Tobin did not envision that scholars would use q to assess firm value, and it is not fit for that purpose, particularly in its currently-used simplified form.

We begin by tracing the history of Tobin’s q, starting with its original role as a mean-reverting construct that macroeconomists used to model investment policy. We document how the original version of q morphed into the simplified market-to-book ratio version that law and finance scholars regularly use today to examine how corporate governance, regulatory policy, and other economic phenomenon affect firm value. Whereas macroeconomists rejected this simplistic version of q because of measurement error problems, law and finance scholars embraced it as a proxy for firm value, even as several scholars warned about its inaccuracy, bias, and variability. Moreover, we show that the very scholars who initially warned against the use of Simple q were later mis-cited for the proposition that Simple q, despite its limitations, could nevertheless be used as a proxy for firm value.

We also examine empirically why Simple q represents such a poor proxy for firm value. First, we show how Simple q suffers from non-classical measurement error, which can produce biased coefficient estimates in regressions using Simple q as an outcome variable of interest. Among other things, we reveal how Simple q’s denominator substitutes the book value of a firm’s assets for their replacement cost and why this substitution produces non-classical measurement error. In particular, aggregated book values for firms omit important assets, particularly a sizeable percentage of intangible assets. As a result, firms with relatively high intangible assets generally will have higher measures of Simple q.

We also show that Simple q is inversely associated with the following year’s annual returns, an association that raises questions about empirical studies that use Simple q as a proxy for long-term firm value. We argue that scholars who continue to rely on Simple q as a proxy for firm value should explicitly consider the inverse relationship between q and subsequent returns, and should recognize that the reciprocal of Simple q, the ratio of book value to market value, is a significant risk factor in the Fama-French asset pricing models and their progeny, which generally are not even mentioned in the literature relying on Simple q.

We also demonstrate why our critique of Simple q matters by revisiting the results of an especially influential study in corporate governance that utilized Simple q as a proxy for firm value. Our replication analysis shows that the associations between governance and q documented in this study depend on the use of Simple q and do not hold for an alternative measure of q that potentially addresses some of the measurement errors in Simple q that we document. Our replication analysis also underscores how the misuse of Tobin’s q can have significant consequences for the conclusions of some of the most cited academic studies in business law and finance.

Finally, we suggest a variety of alternative approaches to examining how firm value is affected by corporate governance and regulatory policy. First, there are alternative measures of Tobin’s q, other than Simple q, that address some of the measurement problems of Simple q. Second, there are alternative techniques that do not rely on q, including the analysis of stockholder returns as well as direct estimates of firm value. For instance, scholars in the related field of accounting have long eschewed using Tobin’s q—in any form—as a proxy for firm value, choosing instead to measure improvements in firm value directly by estimating changes in a firm’s market value of equity.

We view the use of direct estimates of firm value as especially promising for scholars working within the law and finance research tradition. For one, adopting the approach utilized in the accounting literature for measuring firm value has the benefit of allowing scholars to estimate directly how corporate structure and regulatory policy affect firm value. Additionally, by expressly measuring firm value, we hope it might also encourage greater scrutiny of the econometric challenges associated with examining changes in firm value. Most notably, given the increasing use of panel datasets to identify causal effects in corporate governance research, expressly measuring year-over-year changes in firm value may induce scholars to be more attentive to adjusting for serial correlation as well as whether the popular fixed effects estimator (relative to the first difference estimator) is likely to produce biased estimates of the predictors of firm value.

In sum, q—especially Simple q—does not mean what many scholars seem to think it means. Absent more robust testing, the conclusions in the empirical finance literature that rely on q as a dependent variable are unsound and should not be the basis for academic inquiry or policy decisions. Instead, scholars and policy makers should approach studies based on q with caution, and should seek alternative methodologies to assess the correlates of firm value.

Our examination of q is an example of a broader phenomenon: the emergence of path-dependent yet haphazard ideas in intellectual history. We hope to follow other scholarship addressing how such ideas can gain traction in academia, but later are exposed as inaccurate. Our hope is that in the future scholars will look back on the misuse of Tobin’s q as an interesting historical anecdote, a surprising wrong turn, but one that has been superseded by more careful, scientifically-justified analysis in empirical law and finance.

The complete paper is available here.