The Q ratio compares a company's market value to the total value of its assets. When the ratio of market value to assets is less than one, a company's shares are considered undervalued. When the ratio is higher than one, a company's shares are fully valued to overvalued. Also, a high ratio indicates that a business is earning an above-average return, so it can expect increased competition. The concept is based on the belief that a company should be worth what it would cost to replace the business.
The Q ratio is calculated as the market value of a company's debt and equity, divided by the replacement cost of its assets. The formula is:
Market value of outstanding debt and equity ÷ Replacement cost of assets
For example, a business has 1,000,000 shares of common stock outstanding, which currently sell on a stock exchange for $6 each. The replacement value of its assets is $4,000,000. The calculation of its Q ratio is:
(1,000,000 shares x $6/share) ÷ $4,000,000 replacement cost
= 1.5 Q ratio
The obvious problem with this ratio is the difficulty of arriving at a replacement cost for a company's assets, since this information is not reported in its financial statements. Another issue is that the ratio does not factor in the value of intangible assets, such as employees, training, customer loyalty, and branding.