The Misuse of Tobin's Q

We examine the common and growing misuse of Tobin’s q as a proxy for firm value within the law and finance literatures. We trace the history of Tobin’s q, beginning 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 regulatory policy, corporate governance, and other economic phenomena. 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. In addition, we demonstrate empirically why the simplistic version of q is so problematic. 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. We also confirm, consistent with macroeconomists’ view of the original Tobin’s q, that the market-to-book estimate of q is mean-reverting in terms of stockholder returns. Finally, we suggest a new approach. We replicate the details of one leading study that was based on the simplistic version of q and then show how its results differ when we employ several alternative approaches. We propose that scholars should use these alternative approaches, including direct estimates of firm value instead of the simplistic market-to-book ratio, and, when possible, should supplement the popular fixed effects estimator with the first difference estimator. Overall, our message is straightforward: scholars should view with suspicion any assertions about corporate governance and regulation that are based on the use of market-to-book ratios as the dependent variable in regressions.