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TheStreet Open House

When Is a Bubble Not a Bubble?

Sector bubbles are more frequent than market-wide bubbles, but still rare. The biotechnology sector experienced a bubble between 2005 and 2006, when the sum of listed biotech companies' market capitalization was about $450 billion (excluding the traditional large pharmaceutical companies that were investing in biotech). Making some assumptions about future margins, one can estimate that these companies would need to earn $600 billion in revenues in 2025 (in 2006 dollars) to justify these prices. To put that into perspective, all the listed pharmaceutical companies combined earned about $600 billion of revenues in 2006.

Company-specific bubbles are hard to find too, and sometimes misnamed. Imagine a sharp share-price drop for a pharmaceutical company that announces its promising new drug has failed in clinical trials. The steep decline doesn't indicate that the price was originally at a bubble level; the original price might have reflected a reasonable estimate of the company's value given a reasonable estimate of the drug's probability for success.

Brinker International (EAT), however, is an example of a company that experienced a bubble in the early 1990s. At that time, Brinker, which has 1,700 restaurants (including the Chili's chain) in 27 countries, increased its revenues by more than 20% per year, with improving margins. In 1993, its market capitalization reached $2.1 billion with a P/E ratio of greater than 40 times. But eventually same-store sales began to decline, and the market realized the company's economics were vulnerable. In 1994, Brinker's market cap dropped by 61% to a more reasonable P/E ratio in the high teens.

Although not common, the fact that bubbles do sometimes occur -- that is, prices do sometimes deviate from the fundamentals -- makes it even more important for corporate managers and investors to understand the true, intrinsic value of companies. They may be able to exploit any market deviations if and when they occur, for example, by using shares to pay for acquisitions when those shares are overvalued by the market. But more importantly, they will not make decisions based on what may be the unreasonably high price of their stocks, only to be surprised when those prices return to more normal levels, which they always do.

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