Question

The past year dividend was INR 12 and the expected subsequent dividend growth is 5% per annum as per the analyst’s conference call with the management.

The company is expected to pay these dividends in perpetuity. The current share price of a firm that you are tracking is INR 70 per share. You go back to basics and look at this firm’s returns over the past 5 years and using the monthly re- turns, you arrive at a beta of 2. The market return is 13.5 percent.

The yield for the government security which is typically considered to be risk free is 6 percent. What do you think about this stock’s current price in the market?

If you are ex-pected to give a guidance based on the above information, what will be your rec-ommendation on this stock?

Next, if you receive new information that the overall risk aversion in the market has decreased by 250 bps owing to opening up of the market and the monetary policy committee is expected inflation to go up by 50 bps, what is the impact on the expected return, will you change your guidance now?

Answer 1

First we calculate required return on the stock.

required return on the stock = risk-free rate + beta of stock*(market return - risk-free rate)

required return on the stock = 6% + 2*(13.5% - 6%) = 6% + 2*7.5% = 6% + 15% = 21%

now we calculate intrinsic value of stock.

intrinsic value of stock = last dividend paid*(1+dividend growth rate)/(required return on the stock - dividend growth rate)

intrinsic value of stock = 12*(1+0.05)/(0.21 - 0.05) = (12*1.05)/0.16 = 12.6/0.16 = 78.75

this stock's current price in the market is undervalued because market price of 70 is lower than its intrinsic value of 78.75.

your recommendation on this stock will be to buy this stock because its cheaper than its intrinsic value.

100 bps is equal to 1%. so 250 bps is 2.5% and 50 bps is 0.50%.

if the overall risk aversion in the market has decreased by 250 bps then market return will decrease by 2.5%. so, new market return will be 13.5% - 2.5% = 11%. if expected inflation to go up by 50 bps then risk-free rate will also go up by 50 bps because risk-free rate = real interest rate + inflation rate. so, new risk-free rate will be 6% + 0.5% = 6.5%.

new required return on the stock = 6.5% + 2*(11% - 6.5%) = 6.5% + 2*4.5% = 6.5% + 9% = 15.5%

the required return has decreased by 21% - 15.5% = 5.5%.

intrinsic value of stock = 12*(1+0.05)/(0.155 - 0.05) = (12*1.05)/0.105 = 12.6/0.105 = 120

No, you will not change your guidance now because market price of 70 is still lower than its intrinsic value of 120.