Question

An investment analyst has forecast the following for three stocks.  

R_f = 4%   E(R_mkt) = 12%

Stock Price Today E (price in 1 year) E (dividend in 1 year) Beta

A $30   $35 $0.28 1.0

B 55 58 .95 .7

C 80 92 .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.

·        Based on the calculation, determine whether these stocks are overpriced, underpriced or fairly priced. Support your answer.

·        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

Stock	Price today	Expected price in 1 year	Expected dividend in 1 year	Beta	Forecast return	Required return	Valuation
A	30	35	0.28	1	17.60%	12.00%	Underpriced
B	55	58	0.95	0.7	7.18%	9.60%	Overpriced
C	80	92	0.52	1.3	15.65%	14.40%	Underpriced

Methodology

Forecast return = (E(price)+E(dividend)-Price(today))/(price(today))

For example stock A

Forecast return = (35+0.28-30)/30 = 0.176 = 17.6%

Required return = Rf + beta*(Rm-Rf)

Rf=4% & Rm=12%

For example stock A

Required return = 4%+1*(12%-4%) = 12%

If forecasted return > expected return, then under priced

If forecasted return = expected return, then fairly priced

If forecasted return < expected return, then overpriced