Question

1.      For this question we will be using P/E ratio.

To find a company's P/E ratio, use www.morningstar.com , enter the Johnson and Johnson stock symbol (JNJ) and request a basic quote. Once you have the basic quote, the P/E ratio is listed on a front page under Key Stat.

Compare the P/E ratio of your company with the industry average. Is there a difference between these two numbers? Is the stock overvalued, undervalued, or properly valued? Why? In accordance with your findings, is it reasonable to buy the stock? Please explain your answers.

2.      The articles also discuss the risk of the stock. To estimate the risk of the stock we can use beta. Beta is listed under Trading Information – Stock Price History. What is the beta listed for the company? What does it mean? Will it change your decision in question #1 to buy the stock or not? Please explain your answers.

3.      Apply the Capital Asset Pricing Model (CAPM) Security Market Line to estimate the required return on stock. Note that you will need the risk-free rate and the market return.

a) To get the current yield on 10-year Treasury securities go to www.finance.yahoo.com -click on Markets - U.S. Treasury Bonds Rates. You will use the current yield on 10-year Treasury securities as the risk-free rate to estimate the required rate of return on stocks.

b) Between 1926 and 2014, the compound annual rate of return of S&P 500 is estimated a 10.5%. We will use this number as the market return.

c) Calculate the required return on the stock using the Capital Asset Pricing Model (CAPM) Security Market Line. Please show your work.

4. There are several methods how to calculate the growth rate. One of the possible ways is to calculate the sustainable growth rate as g = ROE *(1- Dividend payout ratio). You can find ROE and the Dividend payout ratio on www.morningstar.com.

Calculate the company’s sustainable growth rate. Please show your work.

5. Apply Gordon model (constant growth rate model) to calculate the intrinsic (economic) value of the stock. Please show your work.

Please note that for some companies it is not possible to use Gordon model. If that is the case, please explain why it is not possible to use this model for your company. What other models is it possible to use?

6. Compare the result of your calculations with the current stock price. Is stock overvalued, undervalued, or properly valued? Why? In accordance with your findings, is it reasonable to buy the stock? Will it change your decision in questions #1 and 2? Please explain your answers

Answer 1

1-

As per www.morningstar.com and entering the stock quote gives the following info:
Stock Price= $ 82.30 (on 5th Feb,2018) and PE Ratio = 21.1
Going to the "Industry Peers" section shows that the Industry Average PE Ratio is 27.2
This implies that investors are willing to pay $27.2 per $ income for Exxon's Industry Peers but only $ 21.1 per $ income for Exxon itself. This shows that the price is cheap in terms of forecasted future earnings.
Hence, the stock is undervalued relative to its peers.This in turn implies that investors are not very positive about the company's prospects going forward, as any positive prospects would already have been incorporated into the stock's price(Exxon's Price assuming EMH is true).
Hence, the stock might not be a good buy. However, it might be the case that the stock has positive prospects ahead thereby making it a good yet undervalued stock. In such a case it might be a good investment.
Beta of a company is a measure of the risk of a stock's return with relation to the risk of a market index's (or any benchmark's) return. For example a beta of 1.5 implies that the stock's return is 50% more risky as compared to that of the market index's return. In other words the stock has a volatility which is 50% greater than the benchmark index's volatility.
The volaitility of Exxon Mobil is 0.70. This value shows that Exxon Mobil has lesser volatility as compared to the benchmark index and is therefore a relatively safe stock. Hence, this might be bought in case the investor is risk averse and feels that the low PE Ratio is infact a sign of the stock being undervalued (and not a forecast of some negative event in future).

Answer 3

CAPM - Expected rate of return calculte as follow   
ra = rrf + Ba (rm-rrf)  
  
where:  
rrf = the rate of return for a risk-free security   
rm = the broad market's expected rate of return   
Ba = beta of the asset  
  
so ,  
2.27 % +1.1*(10.50%-2.27%)  
11.21% = Expected rate of return   

Answer 4:

From Morningstar, we get
ROE = 15.01%, payout ratio = 58.85%
Sustainable growth rate, g = ROE x (1 - payout ratio) = 6.18%
b) Gordon growth model, P = D0 x (1 + g) / (r - g)
D0 - Current Dividend = $1.16, r - Cost of equity = 2.8% + 1.54% x (10% - 2.8%) = 13.89% using CAPM
=> Intrinsic Value, P = 1.16 x (1 + 6.18%) / (13.89% - 6.18%) = $15.97

Answer : 5

From Morningstar, we get
ROE = 15.01%, payout ratio = 58.85%
Sustainable growth rate, g = ROE x (1 - payout ratio) = 6.18%
b) Gordon growth model, P = D0 x (1 + g) / (r - g)
D0 - Current Dividend = $1.16, r - Cost of equity = 2.8% + 1.54% x (10% - 2.8%) = 13.89% using CAPM
=> Intrinsic Value, P = 1.16 x (1 + 6.18%) / (13.89% - 6.18%) = $15.97