Question

A stock with a beta of 0.77 currently priced at $45 is expected to increase in price to $65 by year-end and pay a $1 dividend. The expected market return is 17%, and the risk-free rate is 8%. Determine by calculations if the stock is overvalued or undervalued.

Answer 1

Expected return on stock using Capital Asset Pricing Model

= risk free rate + beta of stock ( return from market - risk free rate) = 8 + 0.77(17-8) = 14.93%

Current price of the stock = $45 ; Price at the year end = $ 65 ; Dividend paid = $ 1

Price of the stock = Dividend paid / expected return on stock = 1/14.93% = $6.70

(Assuming zero growth rate model, all earnings distributed as dividend )

With the given information we cannot apply any other model (gordon model, walter model , etc ) to calculate the price of the stock.

Basis the information, fair value of the stock is $ 6.70 and hence this stock is overvalued in the market, since the current price is $45.

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