Question

An investment company is considering investing into one of the following stocks with the risk and return characteristics given below:
Risk free rate = 5.1%    
Average market rate = 7%

Stock Exp. Rate Beta
A 18% 1,5
B 16% 1,3
C 18% 1,85
D 6% 0,9
E 5.5% 0,7
F 5.8% 0.7

Required:
1. Determine which stocks are overvalued and which are undervalued in comparison with market fair determination of required returns. Provide your reason why you think they are over or undervalued
2. Which stock is definitely better than which stock even without the calculations and why?
3. Which stock seems the best investment alternative and why?

Answer 1

1.
Assuming 7% given is market return and not market risk premium

Required return=risk free rate+beta*(market return-risk free rate)

A:
=5.1%+1.5*(7%-5.1%)=7.95%

B:
=5.1%+1.3*(7%-5.1%)=7.57%

C:
=5.1%+1.85*(7%-5.1%)=8.615%

D:
=5.1%+0.9*(7%-5.1%)=6.81%

E:
=5.1%+0.7*(7%-5.1%)=6.43%

F:
=5.1%+0.7*(7%-5.1%)=6.43%

A stock is fairly valued when expected return is equal to required return. No stock is fairly valued

A stock is undervalued when expected return is more than required return. Stock A, B, C are undervalued

A stock is overvalued when expected return is less than required return. Stock D, E, F are overvalued

2.
Stock F is better than Stock E because despite having same beta Stock F provide higher return

Stock A is better than Stock C because despite having lower beta Stock A has same return

3.
Stock A seems the best alternative because it provide the highest alpha i.e., expected return-required return