Question

from the following information, determine whether or not stock A is over- or under -valued. why?

	Stock A	Stock B	Stock C	Stock D	Stock E
Beta	0.70	1.00	1.15	1.40	-3.30
Actual Return	8%	6.20%	15.15%	5.15%	6%

Referring to the previous question, how will stock A move toward the equilibrium price?

Answer 1

In the given Stocks, there is Stock B with Beta 1 (equal to market beta).

If a Stock's beta is more than 1, the rate of return expected from that stock will be higher tham market rate of return and vice-versa.

In the given question, the Beta of Stock is less than 1 (0.7), so the expectations of the shareholders will be to have a return of less than 6.2% (market rate of return). But actually, the stock is earning a return (8%) much higher than market return. This means that the stock is underpriced leading to higher return on investment.

This will lead to increase in demand for the Stock A and this will lead to increased demand while the supply remaining constant, pushing the price upwards. When the price increases then the rate of return on such investment will automatically comes down and thus the Stock A will move towards equilibrium.