Share Price Bubbles: What you Need to Know

Share prices can easily become subject to bubbles. One of the most notable share price bubbles in recent history resulted in the stock market crash of 2001. Another recent (and painfully notable) price bubble occurred in the housing market in 2007. That bubble triggered the Global Financial Crisis of 2007 – 2009. For the most part, bubbles eventually correct themselves and prices do stabilize. However, if you get caught in the hysteria you may end up with empty pockets.

Share price bubbles are very difficult to identify at the macro level. However, the easiest way to spot a share price bubble in a specific stock is to scrutinize the fundamentals of the corporations issuing the stock. Compare metrics like the corporation’s P/E Ratio to that of a market index like the S&P 500. Is the P/E Ratio for the company significantly above the ratio for the index? If so, this may be a sign that the share price for a corporation is overvalued and that a price bubble exists.

Another way to spot share price bubbles is to be realistic about the growth potential of a corporation. Since the fair value of a share is often determined using the Discounted Cash Flow method of valuation, and since this method requires assumptions related to growth potential, make sure that investors are realistic about growth expectations. If you determine that growth expectations for a corporation seem grossly overstated, then that may be a sign to stay out (or get out if you hold the stock). These are just a few examples of how you might be able to identify market hype and profit from it.

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