Contents - Index

Motivation
©2009 OS Financial Trading System

  
The relationship between intrinsic or fair value and market prices is controversial.  The efficient markets hypothesis asserts that market prices generally provide an unbiased and the best estimate of fair values because they self correct when they deviate too far away from predicted equilibrium values.  Behavioral finance argues that cognitive biases and other imperfections can prevent prices from self correcting.  This debate has spilled over into Congressional hearings on Capital Hill after the financial crisis of 2008.  Bailout bill debates in Congress late September 2008 resulted in sections providing the SEC with the power of suspending fair value accounting.  
The SEC would have the authority to "suspend, by rule, regulation, or order, the application of Statement Number 157 of the Financial Accounting Standards Board for any issuer...if the Commission determines that is necessary or appropriate in the public interest and is consistent with the protection of investors," Section 132 of the bill.  
However, Hewitt the chief accountant at the SEC until January 2009 refused to suspend FAS 157 but instead worked to improve the standards by developing additional guidance and other tools for determining fair value.  Similarly, the ex Federal Reserve Chairman, Alan Greenspan came under fire on Capital Hill in October 2008 when he admitted that he had placed too much faith in efficient markets which led him to overlook important fundamentals when implementing regulatory policies.   
In this project we address the issue of assessing the intrinsic or fair value of a stock using a residual earnings model applied to companies that we expect are going concerns.  This approach anchors on book value per share.  This is a number that has a lot of empirical support (e.g., a Fama and French factor in their returns model and a number that intrinsic value investors such as Ben Graham and Warren Buffet place a lot of weight upon).  It is a number that is not directly used in a traditional Free Cash Flow approach to valuation and so this provides an interesting different approach that can be used as an important check and balance.  
You are required to adopt the role of an analyst/investor whose problem it is to assess whether the stocks you are working with are under, over or appropriately priced in the market place.  By understanding how the accounting numbers can be used to assess value for stocks where active markets exist provide relevant insights for dealing with cases where no active market exists as required by current accounting standards.