Tobin’s Q
General Considerations
Tobin’s q is a company performance parameter used to assess future investment opportunities. The ratio is defined by dividing the market value of a company by its assets replacement cost (Tobin, 1969). Therefore, when the market value equals the replacement cost, it is believed that the company is correctly valued. The ratio is used to predict the future performance of a firm on the stock market. If the q value is low, that is, between zero and one, the company is considered undervalued, which arouses interest in potential purchasers. Consequently, if the ratio returns a value above one, the firm is overvalued and may be regarded as a sale (Tobin, 1969). In short, Tobin’s Q is used as a dependent variable as it is a comprehensible parameter that has elegant logic behind it.
Possible Flaws
Tobin’s q has some evident drawbacks that are discussed in the current literature. The ratio is based on the asset replacement cost, which may be troublesome to measure, especially when discussing intellectual property (Dybvig & Warachka, 2015). Therefore, inadequate expertise may lead to incorrect conclusions about a company’s performance. Additionally, Dybvig and Warachka (2015) claim that there are inconsistencies in the logic of the ratio since underinvestment increases rather than decreases Tobin’s q. In short, the parameter should be used with caution due to its possible flaws.
Previous Studies
Historically Tobin’s q is used to measure the market-based performance of companies. Singh, Tabassum, Darwish, and Batsakis (2018) use the parameter as a primary variable to measure the importance of corporate governance efficiency. Fu, Singhal, and Parkash (2016) utilize the q value to evaluate operating and market performance and find positive correlations between those notions. Wang (2015) discusses the value relevance on Tobin’s Q and examines the moderating effect of corporate governance on Tobin’s Q. In short, the abundance of empirical knowledge and strong theoretical background allows the use of Tobin’s Q as a market-based performance indicator.
Stock Price
General Considerations
A company’s stock price is also a valuable market-based performance signal. The high stock price is crucial for companies for a variety of reasons, including positive press, decreased takeover risk, and the additional possibility of financing (Murphy, 2019). Therefore, it can be stated that higher stock prices are associated with healthier and more profitable companies. Additionally, Murphy (2019) points out that stock price can be used as a performance indicator for executive management. Indeed, there is often a direct link between the efficiency of managers and a company’s prosperity. Even though there may be exclusions from the general rule, the financial value of market shares may be used to evaluate the company’s overall performance.
Previous Studies
The stock price is widely used as companies’ health indicator in the scientific literature. Andreou, Antoniou, Horton, and Louca (2016) perform a correlational analysis between the decisions made by the top managers and changes in companies’ performance. The study uses 21 attributes to assess managerial competencies and stock price to evaluate the firm’s performance. Habib and Hasan (2017) also study the effect administrative ability has on companies’ effectiveness and financial health. The research use variables similar to those proposed by Andreou et al. (2016), where the stock price is used as a dependent variable that represents the firms’ well-being.
Hutabarat and Tarigan (2016) discuss different metrics used to evaluate the future profitability of investments, including historical data, ROA, ROE, NPM, CR, DTA, and DTE. The researchers mention that current stock price and its fluctuations can be used to evaluate corporate governance (Hutabarat & Tarigan, 2016). Meriç, Kamışlı, and Temizel (2017) also use stock price as a dependent variable while studying the financial performance of banks in Turkey. In short, a significant body of scientific knowledge confirms that stock price can be used to evaluate corporate well-being.
Control Variables
Company Age
Company age can influence the performance of a company; therefore, it is rational to compare the performance of firms of a similar age to acquire unbiased results. Even though the influence of company age is well discussed in the recent literature, the results of the research are inconsistent. On the one hand, Coad, Holm, Krafft, and Quatraro (2017) state that older companies have better access to finances have well-established relationships with all the stakeholders.
On the other hand, Pervan, Pervan, and Ćurak (2017) are more likely to be innovative and flexible, outperforming their older counterparts. A study by Boesso, Favotto, and Michelon (2014) is an excellent example of a study design that controls for corporate age. In short, due to the possible links between the two notions, it is safer to use company age as a control variable while studying company performance.
Company Leverage
Financial leverage is a variable that can influence the performance of a company. According to Hayes (2019), leverage is an investment strategy that uses borrowed money to increase returns on risk capitals. Companies use leverage to finance their assets to increase shareholder value. Research on the matter shows that leverage can either improve or damage a company’s performance depending on various factors. For instance, Tsuruta (2016) states that, on average, increased leverage has a negative effect on firms; however, high-skilled managers can use the borrowed money to boost a company’s performance. In short, the possibility of correlations between company leverage and its financial well-being suggests that this variable needs to be controlled.
References
Andreou, P., Antoniou, C., Horton, J., & Louca, C. (2016). Corporate governance and firm-specific stock price crashes. European Financial Management, 22(5), 916-956. Web.
Boesso, G., Favotto, F., & Michelon, G. (2014). Stakeholder prioritization, strategic corporate social responsibility and company performance: Further evidence. Corporate Social Responsibility and Environmental Management, 22(6), 424–440. Web.
Coad, A., Holm, J., Krafft, J., & Quatraro, F. (2017). Firm age and performance. Journal of Evolutionary Economics, 28(1), 1-11. Web.
Dybvig, P., & Warachka, M. (2015). Tobin’s Q does not measure performance: Theory, empirics, and alternative measures. SSRN Electronic Journal. Web.
Fu, L., Singhal, R., & Parkash, M. (2016). Tobin’s q ratio and firm performance. International Research Journal of Applied Finance, 7(4), 1-10.
Habib, A., & Hasan, M. (2017). Managerial ability, investment efficiency and stock price crash risk. Research in International Business and Finance, 42, 262-274. Web.
Hayes, A. (2019). Leverage. Web.
Hutabarat, F. M., & Tarigan, D. (2016). Financial performance based on profitability, solvency and its impact on the stock price of companies listed in the mining sector at Indonesia Stock Exchange from year 2006-2014. Journal of International Scholars Conference, 1(3), 35-44.
Meriç, E., Kamışlı, M., & Temizel, F. (2017). Interactions among stock price and financial ratios: The case of Turkish banking sector. Applied Economics and Finance, 4(6), 107. Web.
Murphy, C. (2019). Why do companies care about their stock prices? Web.
Pervan, M., Pervan, I., & Ćurak, M. (2017). The influence of age on firm performance: Evidence from the Croatian food industry. Journal of Eastern Europe Research in Business and Economics, 2017, 1-9. Web.
Tobin, J. (1969). A general equilibrium approach to monetary theory. Journal of Money Credit and Banking 1 (1), 15–29.
Tsuruta, D. (2016). Variance of firm performance and leverage of small businesses. Journal of Small Business Management, 55(3), 404-429. Web.
Singh, S., Tabassum, N., Darwish, T., & Batsakis, G. (2018). Corporate governance and Tobin’s Q as a measure of organizational performance. British Journal of Management, 29(1), 171-190. Web.
Wang, M. C. (2015). Value relevance of Tobin’s Q and corporate governance for the Taiwanese tourism industry. Journal of business ethics, 130(1), 223-230.