The word “bubble” is tossed around quite a bit in the financial markets, but it’s rarely used correctly.
See, the thing that defines a bubble isn’t that valuations are extremely high, or that expected returns are extremely low.
Instead,
what defines a bubble is that investors drive valuations higher without simultaneously adjusting expectations for returns lower.
That is, investors extrapolate past returns based on price behavior, even though those expectations are inconsistent with the
returns that would equate price with discounted cash flows.
In March 2000, at the height of the technology bubble, I noted: “Over time, price/revenue ratios come back in line.
Currently, that would imply an 83% plunge in tech stocks. If you understand values and market history, you know we’re not joking.”
The following month, I discussed Modigliani’s quote above, and detailed the dynamics he was describing.
The collapse of the 2000 bubble would ultimately erase half the value of the S&P 500, and would take the tech-heavy
Nasdaq 100 down an implausibly precise 83%.
The defining feature of a bubble is inconsistency between expected returns based on price behavior and expected returns
based on valuations. If investors pay $150 today for a security that will deliver a single $100 payment a decade from now,
but they also fully understand that they’ll lose 4% annually on the deal, without extrapolating past gains into the future,
then we might say the security is overvalued, and we might question why investors would accept that trade, but we can’t call it
a bubble.
But if investors pay $150 today for that security, because they look back in the rear-view mirror,
decide that it “always goes up” over time, and convince themselves that expected future returns are always positive,
then you’ve got a bubble. Discounting the future $100 cash flow of the security using any positive expected return would produce
a price less than $100. So the positive returns expected by investors are inconsistent with the returns that would equate price with
discounted cash flows. The size of the bubble is the fraction of the market price that represents expectational “hot air.”
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So we LTH are in a position where we confidently expect a big pay out some years from now, but others "don't get it".
That is because the others don't see the price going up. They are in Buffet's impatient category.
Some posters here and elsewhere seem to think that more usual DCF ratios should apply. They are ignoring the risk, and ignoring the lack of
significant actual earnings today. IMO the main risk is delay.
For projected earnings the second approach is warranted, and then the DCF that is to be applied is one which reflects the risk of
failure. IMO BigPharma are applying rates of circa 40% at end of phase 3 trials and something like 70% at the beginning.
@Mozzarc has posted comparisons of BigPharma transactions. DYOR.
Personally, i think QE has caused a semi-permanent dislocation between price to earnings ratios.
By that i mean until the next bout of inflation.
In the late 70s it was the oil price.
It looked like being the oil price several years ago but shale oil put an end to that.
Food for thought?
The net of my own review is to not expect a rocket take-off any time soon. I am holding for the big pay-off some years out at
@Mozzarc levels.
IMO DYOR.
(20min delay)