Question

An analyst determines that three stocks have the following characteristics: Stock Beta, Forecast return X 1.0 10% Y 1.6 16 % Z 2.0 14 % If the risk-free rate is 4% and the expected return on the market is 10%, which stock is: Overvalued? ....... Undervalued?...... Properly valued? ....... (Show your work)

Answer 1

Risk free rate = RF = 4% and Expected return on market = RM = 10%

For Stock X,

Beta = 1 and Forecast return = 10%

Then according to CAPM, Expected return of stock X = RF + Beta (RM - RF) = 4% + 1(10% - 4%) = 4% + 6% = 10%

Since expected return of the stock according to CAPM is equal to forecast return, hence Stock X is properly valued.

For Stock Y

Beta = 1.6 Forecast return = 16%

Then according to CAPM, Expected return of stock Y = RF + Beta (RM - RF) = 4% + 1.6(10% - 4%) = 4% + 1.6 x 6% = 4% + 9.6% = 13.6%

Since the forecast return of stock Y is more than the return expected according to CAPM, therefore it has a low level of risk in comparison to forecast return. Hence Stock Y is undervalued.

Stock Z

Beta = 2 . Forecast return = 14%

Then according to CAPM, Expected return of stock Z = RF + Beta (RM - RF) = 4% + 2(10%-4%) = 4% + 2 x 6% = 4% + 12% = 16%

Since the forecast return of stock Z is less than the return expected according to CAPM, therefore it has high level of risk in comparison to forecast return. Hence Stock Z is overvalued.