Question

Client’s Investments:

1. Lloyds Ltd., is a publicly listed Australian company that your client is following closely, however your client does not have the requisite skills to evaluate the company and, as such has provided you with sufficient information. The historical price of Lloyds Ltd. is given below. Lloyds Ltd. is closely integrated with the Australian economy and so the rates of return for the Australian economy as a whole can be used in the evaluation process.

You know that Australian Treasury bills currently pay a return of 4% p.a., the stock market return over the same period averaged 10% p.a., and have calculated the standard deviation of the market returns to be 12% p.a. Lloyds Ltd. beta is estimated at 1.40. Lastly, you have identified the historical returns and dividends (below).

Year Price Dividend

2009 $3.60

2010 $3.25 $0.30

2011 $3.65

2012 $4.50 $0.35

2013 $4.45

2014 $4.68 $0.45

2015 $5.21

2016 $6.01 $0.50

Using the above information, identify whether it is a good idea, for your client, to invest in Lloyds. Explain your reasoning for your decision.

Answer 1

First, we calculate the expected return on Lloyd’s using CAPM.

As per CAPM, the expected return = rf + beta*(rm - rf) where rf = 4%, beta = 1.40 and rm = 10%

Lloyd's return = 4 + 1.4*(10-4) = 12.4%

The current stock price is calculated as D1/(r-g)

Since the company pay's dividend in 2018 since it pay's dividends every 2 years

The dividend growth rate over eight years (from 2010 to 2018) = (0.50-0.30)/0.30 =0.6666 or 16.665% every 2 years or 8.3325% every year

The next dividend in 2018 is expected to be 0.583325

Stock price in 2017 = D1/(r-g) = 0.583325/(0.124 -0.083325) = 14.34

Expected stock price in 2017 = $14.34

Current stock price in 2016 = $6.01

So, stock price is expected to more than double as per the intrinsic rate and hence it is a good decision for your client to buy the stock.