What is an asset price bubble?
What is an asset price bubble?
An asset price bubble happens when the market price of an asset becomes excessively above its intrinsic value or fair value. Take the example of a stock, X. Market price of stock X is currently Rs 500. Intrinsic value of stock X is Rs 20. So it can be said that an asset price bubble is there in stock X.
How is intrinsic value or fair value of an asset calculated?
It is important to understand here how the intrinsic or fair value of an asset is calculated. The intrinsic or fair value of an asset is the present value of cash flows that will be generated from owning that asset for the remaining of its life. Present value of cash flows is calculated by discounting the cash flows from that asset in each year by the cost of capital that has been invested in that asset.
Suppose you own an asset that has a remaining life of 4 years. For each of the remaining four years, it will give you annual cash flow of Rs 100. The cost of capital or money that you used for buying this asset is 10%.
Present value of the cash flow in the first year or Year 1 = 100/ (1+10%)^1 = 90.90
Present value of the cash flow in Year 2 = 100 / (1+10%)^2 = 82.64
Present value of the cash flow in Year 3= 100 / (1+10%)^3 = 75.13
Present value of the cash flow in Year 4 = 100 / (1+10%)^4 = 68.30
Sum of the present value of the above cashflows = Rs 316.9865 So intrinsic value or fair value of this asset is Rs 316.9865
In the case of a stock, its intrinsic value is the sum of present value of dividends that the stock will give during its life. In case the stock does not give dividends, the intrinsic value of the stock is the sum of present value of Free Cash Flows to Equity (FCFE) of the company divided by number of its outstanding shares.
Estimation of the intrinsic value of an asset requires a number of estimates or projections to be made. Forecasts regarding expected cash flows from the asset in future years have to be made. Estimates regarding cost of capital need to be made. How accurate is the intrinsic value calculated, depends on the accuracy of these estimates.
The risks with asset price bubble
The risks with asset price bubbles is that of bursting of the bubble. When the price of an asset becomes too much in excess of its fair value then a stage comes when selling in the asset starts happening. Simultaneous selling by a large number of investors causes a crash in the price of the asset. The price of the asset falls sharply in just a few days. So the stock X in our example above may see its price falling from Rs 500 to Rs. 20 in just a few days.
Due to this sudden crash in the price of the asset, many investors face significant losses at the same time. This may have a multiplier adverse impact on the economy. This is because the wealth in the economy goes down due to large number of investors facing losses at the same time.
Bursting of asset bubbles may cause financial crises
A number of financial crises in the past took place because of bursting of asset price bubbles. The most recent of these crises is the 2008 financial crisis. A bubble had built in real estate prices in US. When this bubble burst in 2008, house prices fell down sharply. Defaults on home mortgage loans jumped sharply because of this. Investors holding mortgage backed securities saw the value of their investments get wiped out. The entire system soon started feeling the impact of the crisis. Lehman Brothers, that was a major investor in mortgage backed securities, went bankrupt. The crisis soon spread from United States to many other countries of the world.