Question

The risk-free rate is 5%, beta is 1.18, the expected dividend is 6.50, the expected return on the market is 18.7%, the growth rate is 5.73%, the current price is 19.76.

Based on the result decided whether you are going to buy, sell, or hold stock. If you are going to sell or buy stock at what price are you going to do so?

Answer 1

Using CAPM model to calculate expected return

Expected return= Risk free rate + beta (market return - risk free rate)

= 5% + 1.18 (18.7% - 5%)

= 5% + 1.18 (13.7%)

= 5% + 16.166%

= 21.166%

Expected return of stock as per given price $19.76

Price = 6.50 / (cost of equity - growth rate)

Cost of equity = 6.50 / price + growth rate

Cost of equity= 6.50/19.76 + 0.0573

Cost of equity= 0.32895 + 0.0573

Cost of equity= 0.38625 or 38.625%

Intrinsic value of stock

Price = expected dividend / ( cost of equity - growth rate)

= 6.50 / ( 0.21166 - 0.0573)

= 6.50 / 0.15436

= $42.11

From the above calculations, we can see that the expected return of stock is more than the expected return of CAPM, which makes it undervalued stock. As the stock is undervalued, we should buy the stock at current price i.e. $19.76 and hold it until it reaches its intrinsic value.