When Is a Bubble Not a Bubble?

The following article has been adapted from "Value: The Four Cornerstones of Corporate Finance" by McKinsey & Co.'s Tim Koller, Richard Dobbs and Bill Huyett. The publisher is John Wiley & Sons.

It's easy to construe all instances of sharply rising, then falling, stock prices as bubbles, but most of the time they're not.

True stock-price bubbles are essentially nonexistent at the level of the aggregate economy, very rare in specified industry sectors and not common for individual companies. The fact that they are so rare makes it all the more important for the value-minded executive to be able to spot them.

What, then, is a bubble? Bubbles occur when one group of investors irrationally pushes a stock price far above a level that can be justified by its potential financial performance, and other, often more sophisticated investors, aren't able to offset the actions of the less rational investors due to structural constraints and the liquidity risks of shorting stocks.

Financial crises are often described as bubbles, but they're not the same. Bubbles are the rise and fall of company share prices. An unlike debt, equities don't have maturity dates or covenants that can allow the holder to immediately demand cash from the company. Therefore, when bubbles burst, they don't have a drastic effect on the economy (unless they're accompanied by large amounts of debt).

Financial crises, on the other hand, do have a dramatic and far-reaching effect on the real economy, because they're brought about by excessive financial leverage, which has a negative domino effect when the value of the underlying assets falls and those who owe the debt can no longer service it. The debt crisis causes an economic downturn, which then causes the stock market to decline. But we can't call this a bubble if stock prices were reasonably valued in light of the economic conditions before the crisis.

A good example of a stock bubble was when 3Com (COMS) spun off its Palm subsidiary 10 years ago. Immediately after the share sale, the market capitalization of Palm was $45 billion. At the same time, 3Com's market cap was only $28 billion, even though it owned 95% of Palm (presumably worth $41 billion). The only way that 3Com could be worth 60% of Palm would be if the rest of 3Com's businesses were worth negative $13 billion!

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