Guide to Analysing Companies

ESSENTIAL FINANCE
01 Essential Finance 10/11/06 2:21 PM Page 10

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reflect fundamental values and to price in all available informa-
tion. If ill-informed investors move prices away from their true
value, informed ones will simply arbitrage them back again. 
Purists believe that if share prices rise to a level for which
there is no obvious explanation, then investors will conclude
that there is another less obvious explanation, such as the dawn
of a new age of productivity or, as dotcom enthusiasts believed
at the time, a “new economic paradigm”. What believers will
not conclude, at least until after it has burst, is that a bubble
exists – which, of course, is both irrational and inefficient.
Many observers would like to see the Federal Reserve and
other central banks attempt to control not just the level of infla-
tion, their main preoccupation, but asset prices too. They argue
that the costs of pricking an inflating bubble – possibly reces-
sion, deflation or sometimes a combination of the two – out-
weigh the risks of raising interest rates pre-emptively to prevent
a bubble forming. After all, argue interventionists, history is lit-
tered with examples of the results of inaction on the part of
central banks that have resulted in problems of a comparable
magnitude; for example, Japan’s prolonged period of economic
stagnation and occasional deflation following the bursting of its
own asset-price bubble in the early 1990s.
The danger, of course, is that when a bubble does burst, its
impact can be far-reaching, not just on the financial markets but
also on the underlying economy. The wealth effect, which helps
to boost consumers’ confidence and so propel share prices ever
higher when markets are rising, also works in reverse. Equally
damaging can be the sudden loss of confidence produced by a
realisation on the part of investors, particularly private ones,
that they have been duped.
Revelations in 2002 by Eliot Spitzer, the crusading attorney-
general of New York State, that investment banks on Wall Street
had routinely touted shares in public which they privately be-
lieved to have been “junk” had a predictable result. Aggrieved
that they had been misled when they bought the shares of com-
panies seeking initial public offerings during the heady days of
the technology boom, investors called their lawyers and sued. It
was not so much the knowledge that investment banks suffered
from conflicts of interest – Wall Street has long had to balance