Question

Under/Over Valued Stock A manager believes his firm will earn a 17.4 percent return next year. His firm has a beta of 1.64, the expected return on the market is 15.4 percent, and the risk-free rate is 5.4 percent. Compute the return the firm should earn given its level of risk and determine whether the manager is saying the firm is under-valued or over-valued.

Answer 1

Based on CAPM, Required Return on a stock = Risk free rate + Beta * (Expected market Return - Risk free rate)

Required Return on a stock = 5.4% + 1.64 * (15.4% - 5.4%) = 5.4% + 16.4% = 21.8%

Required Return > Expected Return on this stock

Based on simple rules of CAPM:

If expected return > Required return - firm is undervalued

If expected return < Required return - firm is overvalued

If expected return = Required return - firm is fairly valued

Hence, for our question, the firm is OVERVALUED.