Impact of Tobin’s q, Capm, and Mpt Measures on Stock Valuation and Investment Decision

Abstract

Investments in stocks have been lucrative investment opportunities nowadays not only for limited dividend payments but also for abnormal returns undertaking more risks. Several financial theories have been incorporated in hedging risks, and enhancing profitability of portfolio compositions. This study aims at examining portfolio returns based on three assumptions namely Tobin’s Q ratio, capital asset pricing model, and modern portfolio theory. The Q ratio determines the firm’s present value compared to its replacement costs of its assets. The capital asset pricing model (CAPM) describes the relationship between systematic risk and return on an asset setting a risk-free rate. On the contrary, the modern portfolio theory enhances overall portfolio returns within a considerable risk exposure. The mathematical framework represents an absolute value, which signals the future share price movements, thus assisting investors in selecting optimal portfolios. The study considers 100 blue-chip companies from Nasdaq’s 100 index in assessing share performance over time. The analysis comprises technical analysis, the measurement of future stock returns according to the behaviors in the past. Taking into account only the blue-chip companies, we found some abnormal results, which represent the volatility of stock market. It is evident from the study that regardless by the measurement tools and techniques, most often investors just try to predict the future price changes, yet the outcome is not guaranteed. However, this paper examines a clear insight according to these benchmarks to the individuals in making rational portfolio mix to maximize overall returns.
Keywords: Tobin’Q, MPT, CAPM, portfolio returns, risk.
Jel-kód: E22, G11, G12, G31, G32

Introduction

Investment on stocks has been considered as the most attractive investment strategies in finance. For every company, the ultimate objective is not to maximize profit, but to maximize the shareholders’ wealth. Once the funds are collected from various sources at the lowest possible costs, it is important to utilize the funds efficiently and effectively in order to cover the costs of capital. Management of every single company is deeply concerned about their stock returns as the share performance reflects the company’s growth and sustainability in the long run. (Guo, 2002) highlighted the correlation between stock market returns and future economic growth, indicating the predictive power of stock returns. Though it’s a very complex task to determine the future price of a share, several tools and techniques are commonly used to predict stock price variation.

In addition, a company’s share performance provides clear overview to the prospective investors in making sound investment decisions regardless by the nature of investments. Apart from others, share performance of a particular firm can be assessed in different angles applying Tobin’s Q ratio, capital asset pricing model (CAPM), or the Modern Portfolio Theory (MPT). This study aims to build a relationship among these three in making individual investment choices.

Literature Review

Tobin’s Q ratio, which typically compares a company’s market value to its replacement cost, is an important component in many areas of its performance. According to (Blose, 1997), Tobin’s Q was found to have a positive relationship with the stock market response to capital investment plans by implying that it can be used to identify companies with successful investment prospects. (Stevens, 1986) established the importance of returns on equity and dividend payout ratios by developing and estimating nonlinear correlations between Tobin’s Q and financial variables. (Wernerfelt, 1988) emphasized the importance of Tobin’s Q in predicting company performance, analyzing industry and focusing effects as the most relevant elements. (Lin, 2011) investigated the use of Tobin’s Q in examining the stakeholder theory and its impact on corporate social performance, establishing positive correlations.
The Capital Asset Pricing Model (CAPM) is a useful tool for calculating portfolio returns because it provides a framework for understanding the link between risk and return (Chen, 2022). However, its application comes with difficulties. (Handa, 1993) and (Chang, 2011) both signifies the model’s sensitivity to the choice of return measurement period as well as the problematic assumptions of a perfect linear relationship between return and market portfolio risk. Despite these limitations, (Rehman, 2013) suggests that the CAPM is effective in predicting returns in the capital market, especially in recognizing the presence of a risk premium as the primary factor influencing stock returns.
Modern Portfolio Theory (MPT) has had a considerable impact on portfolio management, particularly in the stock market. It highlights the importance of diversity in lowering portfolio risk (Yu, 2023) and provides a methodology for estimating expected returns and acceptable level of risks (Han, 2022). Despite its drawbacks, such as unrealistic assumptions and a lack of attention to macroeconomic aspects (Yu, 2023), MPT remains an important tool for investors, assisting in the selection of an optimal portfolio mix (Han, 2022). Additionally, modern portfolio theory assists an investor in categorizing, estimating, and controlling both the type and quantity of expected risk and return in order to maximize portfolio expected return for a given amount of portfolio risk. (Omisore, 2012)

Methodology of Research

In our study, we chose to conduct a quantitative investigation to determine the best investment strategy among undervalued, normal, and overvalued portfolios. This method consists of collecting numerical data in order to conduct a mathematical analysis. So, for this reason, we started by collecting the data and to enhance the credibility of our values and our study we chose to abstract the data from the Nasdaq’s website. These data are represented in the market value and the total assets of our sample which are the companies of the Nasdaq’s 100 index.
Initially, we calculated Tobin’s Q ratio of the top 100 companies weighted in the Nasdaq index. Additionally, we categorized the selected shares into three portfolios. With the portfolios established, our analytical journey continued as we delved into the evaluation process. The computation of essential metrics, including BETA, Capital Asset Pricing Model (CAPM), and Modern Portfolio Theory (MPT), formed the core of our assessment.
For Beta, we chose to calculate by the method of benchmarking not by the most common method which is dividing the covariance between the market and the share by the variance of the market. This choice was due to the lack of the availability of information.
These quantitative measures provided nuanced insights into risk, expected returns, and portfolio diversification, respectively, enhancing our understanding of the investment landscape and aiding in the identification of the most promising strategies within each valuation category.

Research objective

The majority of investors think that an undervalued portfolio is the best strategy for investments and this is due to various reasons like the potential of higher return, long-term value creation, and quite evidently the possibility of speculation.
So, in this study, we will try to determine if this assumption is valid in every case and if the undervalued portfolio will be the best strategy of investment in our case.
Impact of Tobin’s Q ratio in investment decisions
The Q ratio is computed by dividing a company’s market value by the replacement value of its assets. The Q ratio specifies that the overall market value of all the companies on the stock market should be nearly equal to their replacement costs. A low Q ratio (between 0 and 1) indicates that the cost of replacing a company’s assets exceeds the value of its shares. This means the stock is undervalued. A higher Q ratio (more than 1), on the other hand, indicates that a firm’s stock is more expensive than the replacement cost of its assets, implying that the stock is overvalued.
To summarize, Tobin’s Q ratio gives useful information about a company’s investment efficiency, market timing, merger and acquisition potential, financial decision-making, stock valuation, risk assessment, and statistical comparisons. It is an effective tool that allows investors and financial analysts to make rational predictions based on market activity compared to the assets’ price.
Capital Asset Pricing Model to combat systematic risk
The Capital Asset Pricing Model (CAPM) is a mathematical model that describes the relationship between systematic risk and expected return on assets, particularly stocks. The capital asset pricing model, abbreviated as CAPM, is a financial model that computes the expected rate of return on an asset or investment.
CAPM does this by utilizing the projected return on the market along with a risk-free asset, and the asset’s correlation or sensitivity to the market (beta). This model has certain weaknesses, including as assuming unrealistic assumptions and focusing on a linear analysis of risk vs. return. Despite these limitations, the CAPM method is still widely used due to its simplicity and ease of comparison of investment choices. The Capital Asset Pricing Model is critical in managing systematic risk because it provides a systematic framework for assessing and pricing risk, driving portfolio creation, influencing investment decisions, and supporting successful risk management techniques.
Modern Portfolio Theory in investment decision-making
Modern portfolio theory (MPT) is a realistic strategy for choosing investments to optimize their overall returns while maintaining an acceptable degree of risk. This mathematical framework is used to construct an investment portfolio that maximizes the amount of expected return for the given level of risk. Diversification is a significant part of the MPT theory to justify a large number of investments, they are either high risk/high return or low risk/poor return compositions. Markowitz suggested that investors may obtain the best outcomes by selecting an ideal combination of the two based on their particular risk tolerance.
The MPT is a useful tool for investors who are trying to build diversified portfolios. In fact, the growth of exchange-traded funds (ETFs) made the MPT more relevant by giving investors easier access to a broader range of asset classes. This technique welcomes every investors regardless by their risk-taking attitudes, or the budget constraints.
The MPT’s most serious drawback is that it analyzes portfolios primarily on variance rather than downside risk. That is, under modern portfolio theory, two portfolios with the same level of variation and returns are regarded equally acceptable. The volatility of returns may exist in one portfolio as a result of frequent minor losses. Another reason for the variation could be uncommon but spectacular losses. Investors in general would prefer regular minimal losses that are easier to bear. In contrast, the post-modern portfolio theory (PMPT) seeks to improve on modern portfolio theory by focusing on downside risk rather than variation.

Analysis and Results

In our analysis, the indispensable component of our work is the calculation of the TOBIN Q RATIO. In this regard, we opted to compute the Tobin’s Q ratio for 100 shares of blue-chip companies by dividing the market value of each share by the total assets of the company. Our findings revealed that the Tobin Q ratio for these companies falls within the range of 0.18 and 29.
The noteworthy observation lies in the prevalence of Tobin Q ratios surpassing 1, signifying that a substantial majority of companies listed on the Nasdaq index are currently perceived as overvalued. To elaborate, merely 14% of these companies are considered undervalued, trading below their intrinsic worth. In contrast, only 4% fall within the normal range, implying that the market accurately reflects the value of assets for these selected group of companies.
Conversely, the remaining companies fall into the category of overvalued, characterized by Tobin’s Q ratios ranging between 1.2 and 29. While this outcome may initially seem perplexing, it can be rationalized by considering the unique context of our study. Focusing exclusively on the top 100 companies in the Nasdaq market naturally skews the distribution towards companies that may exhibit a higher degree of overvaluation. This insight underscores the importance of contextualizing our findings within the specific market segment under examination.
In terms of capital asset pricing model (CAPM), we found non-linear relationships between the expected returns of three portfolios. Considering the first portfolio, Diamondback Energy Inc. stands for the highest expected return of 23.41%, while Moderna Inc. experiences the negative yield of of -47.72%. Besides, Walgreens Boots Alliance Inc., Exelon Corp., Baker Hughes Co., and Intel Corp. pose more than 10% returns ranging between 14% to nearly 21%. There are only a few companies, which have an expected return of less than 10%. In contrast, there are 10 companies out of 17 in this composition that have negative expected return taking into account the systematic risk exposure. It can be noted that the results reveal a greater degree of volatility.

Our second portfolio comprises only three companies namely Charter Communications Inc., Comcast Corp., and Netflix Corp. have the greatest return of 16% to 18%. Apart from this, expected return for the other firms amounted below 10% either positively, or negatively. Nevertheless, the results seem strange as returns of eight high-performing companies are negative, indicating a greater volatility. Thus, the negative returns highlight market price fluctuations even in the case of outperformed firms over a period of time.

The third portfolio exhibits the maximum number of companies holding a positive return between 2% to 17% at the most. The statistics shows an ideal scenario as opposed to the other two mixtures. Six companies generate a rate of return of more than 10%, even the rate is approximately 20% for Intel Corporations. Seven companies still obtain an acceptable level of positive return ranging between 2 to 10%, which resulted a positive MPT of 2.49%. Only three companies have slightly negative returns, however, the number is negligible. As a matter of fact, the diversity of expected returns reflects frequent share price movements in the Nasdaq’s 100 index.

Finally, in the view of modern portfolio theory (MPT), the three portfolio mix have an expected return of 3.25%, 2.19%, and 2.49% respectively. The outcome ranges positively between 2% to approximately 3% portfolio returns, taking diversifiable risks into consideration. Because of the variations of returns according to different measures, individuals’ degree of risk taking preferences will have a priority in choosing optimal portfolios. There are kind of investors who love to take more risks compensated by higher returns, some investors prefer to take risks up to a certain level, and some are neutral in the risk-taking behaviors. Additionally, investment strategies may differ due to budget constraints, internal strategies, and market conditions, although there are a lot of investment opportunities, the budget is limited, or a particular firm has some own strategies, or the market seems unpredictable.

From the above results, it is not always obvious that an undervalued portfolio is the best strategy for investment. In our case, the choice of the best portfolio depends on the strategy of investors, and we may also need to calculate some other indicators like the Dividend Discount Model (DDM) or do a qualitative analysis like environmental, social, and governance (ESG) analysis.
Limitation of the study

Tobin’s Q ratio, capital asset pricing model (CAPM), or modern portfolio theory (MPT) have significant role in valuating stock and building perfect portfolio mix. Nevertheless, there are some limitations in finding an appropriate data set to have an accurate result. Because different index reveals separate date set, as a consequence, the results vary between the stock indices. This creates controversy, that may not be a positive sign to the investors. Another thing is, the stock market is highly volatile, as a result, it’s a very complex task to forecast the expected returns based on the previous trends. Furthermore, the desire to have greater returns for taking higher risks seem a zero-sum game, where one party gains from the other party who resulted a loss from his or her investment.

Conclusions

Tobin’s q, CAPM, and MPT are useful tools for making rational investing decisions. Tobin’s q ratio helps assess the relative valuation compared to the replacement costs of assets, CAPM aids in establishing the required rate of return based on systematic risk, whereas MPT guides portfolio construction for optimal risk-return trade-offs. In brief, these three measurement methods help investors in forecasting future outcomes considering risk exposure, market volatility, and other macroeconomic factors. By incorporating these ideas into investment analysis, individuals may create a comprehensive framework for making informed and rational investment choices.

References

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Rania Boukhchim Master’s student, Msc in Finance
Institute of Rural Development and Sustainable Economy
Hungarian University of Agriculture and Life Sciences Sabbir Ahmed Master’s Student, MSc in Finance,
Institute of Rural Development and Sustainable Economy
Hungarian University of Agriculture and Life Sciences, ahmed.

Dr. Sándor Gáspár Assistant Professor,
Institute of Rural Development and Sustainable Economy
Hungarian University of Agriculture and Life Science