Question

A) Suppose the beta of Zenyatta Inc. is estimated to be 1.3, the S&P500 return is 12.6% and the US T-bill rate is currently 1.8%, what is the expected return to Zenyatta stock?

B) If the current market return for Zenyatta is 10%, is this stock over or under valued?

Answer 1

We first need to calculate the expected return of the stock in question, which can do by CAPM equation.

Per CAPM,

Expected Return on Stock = Risk Free rate + Beta * (Expected Market Return – Risk Free rate)

Substituting values in here,

Expected Return on Stock = 1.8% + 1.3 * (12.6% - 1.8%) =15.84%

Since, current return is lower than expected return; this implies stock is currently undervalued. Had the expected return be lower than current return, it would have been overvalued.