When the market expects a firm’s after-tax return on its investments (ROI) to exceed the prevailing discount rate (that is, investors’ anticipated pretax rate of return), the firm’s stock price will exceed the replacement cost of its assets. The firm’s Q ratio (its book/price multiple) will increase as anticipated ROI rises relative to the prevailing discount rate and decrease as anticipated ROI falls relative to the prevailing discount rate.
Over the six three-year periods from 1964 to 1981, inflation-adjusted ROI consistently accounted for about 70 per cent of the variance in corresponding Q ratios, versus only 20 to 60 per cent for traditional historical cost measures. Shifts in net historical cost and inflation-adjusted ROI, however, account for about the same proportion of variance in Q ratios.
Short-term “earnings response” investors and analysts may continue to use unadjusted data. Investors and other decision-makers, however, will arrive at a misleadingly low estimate of the degree to which share price depends on ROI if they rely on historical cost data. If investors think they have no reason to prefer shares in high ROI firms, and if managers have no incentive to discipline their firms in the direction of higher ROI, serious misallocations of investment and other resources could result.