Question

Suppose that the rate of return on the market portfolio is 10% and the risk-free rate is 5%. Consider a stock with beta is 1.3. The firm is expected to have no earnings in the first year (E1 = 0), and then $10 earnings-per-share in the second year (E2 = 10). After that, earnings are expected to grow at a constant annual rate of 8%. The retention ratio is 80% in all periods.

What is the market cap and what is the fundamental value of the stock today at t=0?

Answer 1

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Formulas:

As per CAPM model:

Re= Rf+(Rm-Rf)B

Re= required rate of return.

Rf= Risk-free rate.

Rm = return on the market.

Rm-Rf =Market Risk Premium.

B = Beta, systematic risk.

As per Gordon Growth Model of Stock Valuation:

EV=E/(Re-g)

EV= Enterprise Value.

E= forward Earnings.

g= Growth rate

Re= cost of capital.

M. Cap = $256.25

Value of Stock = $51.25