How can the analysis of risk be integrated into the valuation of common stock? What should happen to the value of common stock if its beta increases?

Solutions

Expert Solution

there are basically two types of risk that affect stock prices:-

1) Systematic risk- the risk which occurs due to large macro economic changes and which cannot reduced by any normal means. The whole industry or the market may get affected due to this type of risk. for example in govt changes its policy regarding import/export of certain goods pertaining to certain type of industry, it will be a systematic risk.

2) Unsystematic risk- these are company/stock specific risk, which mainly depends on the operations and administrative policy changes of the company. these risks are specific to the company only. this type of risk can be managed by diversifying the portfolio of stocks which the investor is investing. for example if due to certain reason stocks of one company falls, other stocks of investor's portfolio may not fall or some may rise. So, the fall in price of the stock is negated by the rise of other stocks in the portfolio. therefore, this type of risk can be minimised by diversification of portfolio.

Both the type of risks are taken into account when the valuation of common stocks are made using different valuation principles. It depends on the exposure to the risks mentioned, that how much will it effect the value of common stock/equity. But mainly the company's OPERATIONAL and FINANCIAL risk are taken into account while considering valuation.

BETA- Beta of a common stock measures the volatility of the price movement of that stock in relation to the volatility of the whole index. So, higher the value of beta means higher volatility of the respective stock relative to the benchmark index and vice versa. So, increase in beta will result in more premium demanded by the shareholders of that stock in order to mitigate their risk due to higher volatility. So, according to CAPM model increase in beta will increase the cost of equity during valuation because cost of equity equals to the risk free rate of return + beta * (risk premium- Risk free rate).

jeff jeffy answered 1 year ago

Next > < Previous

Related Solutions

What is Beta and how can we use Beta to measure risk?

• Standard Deviation and Variance • The CAPM • Beta Coefficient • Common Stock Valuation Models...

• Standard Deviation and Variance • The CAPM • Beta Coefficient • Common Stock Valuation Models • Company Valuations Develop a 300-500 word informational essay about one of the topics

A) What is Beta and how can we use Beta to measure risk. (B) Analyze the...

A) What is Beta and how can we use Beta to measure risk. (B) Analyze the concept of the Security Market Line and how it interacts with the Beta concept to determine an expected rate of return. (C) Provide an example of how you could use Beta to measure risk as a financial manager.

based on the CAPM what should be the beta of beta of a stock that has...

based on the CAPM what should be the beta of beta of a stock that has an expected return of 12%, if the risk free is 3.5% and expected return of market portfolio is 12%?

Basic Stock Valuation: Dividend Growth Model The value of a share of common stock depends on...

Basic Stock Valuation: Dividend Growth Model The value of a share of common stock depends on the cash flows it is expected to provide, and those flows consist of the dividends the investor receives each year while holding the stock and the price the investor receives when the stock is sold. The final price includes the original price paid plus an expected capital gain. The actions of themarginal investor determine the equilibrium stock price. Market equilibrium occurs when the stock's...

1. You are analyzing a common stock with a beta of 1.5. The risk-free rate of...

1. You are analyzing a common stock with a beta of 1.5. The risk-free rate of interest is 5 percent and the market risk premium is 10 percent. If the stock's expected return based on its market price is 19.5%, the stock is overvalued since the expected return is above the SML. the stock is undervalued since the expected return is above the SML. the stock is correctly valued since the expected return is above the SML. the stock is...

"Holding other factors constant, a lower financial leverage increases the beta of the common stock." True...

"Holding other factors constant, a lower financial leverage increases the beta of the common stock." True or false?

explain in detail the concept of risk and its importance how risk in the valuation of...

explain in detail the concept of risk and its importance how risk in the valuation of financial instruments

Recently, an analysis of Caterpillar Inc. found that it’s equity beta (the beta on its stock)...

Recently, an analysis of Caterpillar Inc. found that it’s equity beta (the beta on its stock) is 1.03. The most recent annual dividend is $4.12/share. A survey of economist finds that the perceived market risk premium is around 6.5%. As of Oct 1, 2020, the yield on a 30-year U.S. Treasury was 1.45%. Given this information, answer the following questions. a. Assuming dividends are NOT expected to grow in the future. What is the expected current share price given this...

What is the value of a common stock if:

What is the value of a common stock if: a. the firm's earnings and dividends are growing annually at 4 percent, the current dividend is $1.32, and investors require a 8 percent return on investments in common stock?b. What is the value of this stock if you add risk to the analysis and the firm's beta coefficient is 0.8, the risk-free rate is 1.5 percent, and the return on the market is 8.5 percent?c. If the price of the stock is...

Subjects