3. Stock Valuation A company’s stock just paid a dividend (D0) of $3.50 and the stock’s...

3. Stock Valuation

A company’s stock just paid a dividend (D0) of $3.50 and the stock’s dividends are expected to grow at a constant rate of 4.0% per year. The stock has a beta of 1.2, the risk-free rate is 2%, and the market risk premium is 7%.

a. Is this stock more or less risky than the market? Why?

b. Use the CAPM to compute the cost of equity/required return for the stock (rs)?

c. Use the constant-growth dividend discount model (DDM) to estimate what the price of the stock should be.

d. If you see that this stock is selling for $45.00, would you buy it? Why?

Solutions

Expert Solution

Given about a stock,

Last dividend D0 = $3.5

Expected growth rate g = 4%

beta of stock = 1.2

a). We know that beta of market is 1. So, when a stock has higher beta with compared to market, it means that stock is more volatile as compared to the market. More volatile stocks have higher risk associated with them. So, yes stock is more risky than the market.

b). Risk free rate Rf = 2%

Market risk premium MRP = 7%

So, sing CAPM model, cost of equity of stock Ke = Rf + beta*MRP

=> Ke = 2 + 1.2*7 = 10.40%

So, cost of equity of stock is 10.40%

c). Using Dividend discount model, current price of the stock is given by formula

P0 = D0*(1+g)/(Ke - g) = 3.5*(1+0.04)/(0.104 - 0.04) = $56.88

the price of the stock should be $56.88

d). When actual price of the stock in market is $45, which is less than its intrinsic value. So stock is currently undervalued and is expected to reach it intrinsic value in near future. Sine it is expected to increase in short term, it is a buy.

jeff jeffy answered 1 year ago

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