Question

An investment analyst has forecast the following for three stocks.  

R_f = 4%    E(R_mkt) = 12%

	Price	E (price)	E (dividend)
Stock	Today	in 1 year	in 1 year	Beta
A	$30	$35	$0.28	1.0
B	55	58	0.95	0.7
C	80	91	0.52	1.3

The analyst would like to use the above information to determine whether these stocks are overpriced, underpriced, or at their equilibrium prices? The analyst would also like to show where they plot on the Securities Market Line (SML) graph.

• Include the calculation for the Forecast Return and the Required Return for Stocks A, B and C.
• Plot the three stocks on the SML graph where the x-axis is the beta and the y-axis is the E(R).

Answer 1

formula:

Capital Asset pricing model:

As per CAPM model:
Re= Rf+(Rm-Rf)B

Re= required rate of return.
Rf= Risk-free rate.
Rm = Return on market.
Rm-Rf =Market Risk Premium.
B = Beta, systematic risk.

Concept:
If the actual rate of return is more than the required rate of return than the stock will create value for its shareholder, as the stock return is more than shareholders required expectation.

Actual > Required = Underpriced

Otherwise overpriced.