Characteristics of a Price Bubble

 “A true bubble is when something is overvalued and intensely believed,” he says. “Education may be the only thing people still believe in in the United States. To question education is really dangerous. It is the absolute taboo. It’s like telling the world there’s no Santa Claus.”

After the tech bubble and real estate bubble each burst, there is much discussion as to the next bubble. From what I can tell, there are two popular candidates: education, i.e. tuition, and health care, i.e. insurance premiums. In this post, I’ll discuss the two first bubble candidate. I want to first discuss in general terms what constitutes a bubble.

            

Define the capitalized value of an asset as the present value of its future expected net cash flows (revenues less expenses). A general formula looks like this:

P0 = CF/(r-g)

where P₀ is the price of the asset (capitalized value today), CF is the net cash flow per period, r is the discount rate, and g is the expected growth rate in the cash flow. The discount rate should reflect the time value of money and all the risks faced by the asset holder due to the asset ownership.

For stocks, CF is the free cash flow available to equity holders (FCFE). Free cash flow is available for reinvestment in the firm or to be paid out to equity holders as dividends or stock buybacks. Negative free cash flow means the firm needs financing from outside, whereas positive free cash flow means the firm is generating more internal cash flow than needed to maintain its business.

The capitalized value of the asset increases if expected future cash flows increase, or if the discount rate decreases. Of course there is a lot of noise in those expectations, so we expected capitalized values of assets with noisy information to be at least somewhat volatile.

A price bubble is defined as a price increase that is not generated by changes in expectations of future cash flows or the discount rate. In other words, it is a price increase that is not connected to the fundamentals of the asset. The trouble with identifying a bubble is that market participants can have legitimate (i.e. based on sound research and reasoning) differences in their expectations of the future cash flow that an asset will generate. Further, people can have a different personal discount rate and attitude toward risk, which leads to differences in discount rates.

Now, in stock/bond pricing, discount rates should not deviate much across investors, since the required return is priced by the marginal investor. That means the only thing driving discount rate differences should be risk factors. But, for things like education, I think the story is different.

With education the asset being purchased is predominantly a signal, with some human capital development. It’s not clear at all that the human capital development can only be done through higher education, but that’s another topic. The point is, the expected cash flow generated from the asset is the so-called education premium. In other words, the student is purchasing a higher expected salary. These expectation differ by degree level (Bachelor’s, Master’s, Ph.D.) and by type (Business, Engineering, Arts, etc.).  

The premium of the typical bachelor’s degree over high school is $20,000/year (data here). Now that includes degrees of all types. I don’t have data for different majors. Using data on average tuition from here, the average state school costs is $33,000 for all four years for an in-state student. But wait one minute! Not only is there tuition, there is the opportunity cost of not working full time while in college. Let’s assume the full-time student won’t work, so we’ll add four years of high-school earnings to the investment. That’s $112,000.

Let’s see what the implied capitalization rate is. Take the average degree premium as the dividend and the total investment as the price, we find the implied capitalization rate is 13.7% in this case. This is an enormous discount. The lower the capitalization rate, the higher is the price relative to the dividend. Implied discount rates for out-of-state students are 12.3%, and for private schools it’s 9%.

At first blush I would say there is little evidence of a bubble in higher education. The problem is coming from bad combinations of tuition and degree (major). If your major does not promise greater than $28,000/year in earnings, on average, the college degree you’re getting is (guaranteed) not worth it.

Now, if you go to an in-state school, in order to get a 5% return on your money, you need a salary premium of $7300/year, after tax. That’s $10,400 before tax, assuming an average tax rate of 30% (federal and state). So if you want to score a job that pays off your education, you need to earn around $40,000/year. If you go with a 10% return, you need closer to $50,000/year. This is reasonable for engineering and some science jobs, and some (not many) business majors. You won’t be getting anywhere close to this with a humanities or social science degree.

My argument is that the average college degree pays off the degree holder. But within that are some very bad choices. In the end, the individual must make careful, informed decisions.