Question

You run a regression of X’ Company stock's returns against the market returns over a five-year time period (using monthly data) and come up with the following output: Intercept = .20%, Slope = 1.20

Your stock had an annualized standard deviation of returns of 40% whereas the market standard deviation was only 20%. The annualized risk-free rate, on average, over the last five years has been 6% and it is currently at 7%. The risk premium = 8.5%. The annualized dividend per share currently is $2.00 and the stock is currently selling for $50 (There are 100,000 shares outstanding)

Evaluate the performance of X Company over the five-year time period of your analysis.

Answer 1

The slope in the regression determines the aggressiveness of the stock returns in relation to the market and is known as Beta. The beta for Market is equal to 1 which states that any security/stock whose beta in relation with market is more than 1 is more volatile than market and any security/stock whose beta is less than 1 is less volatile than the market. A beta of 1.2 indicates that this is a highly volatile stock i.e. if the market increases from $1000 to &1100 i.e. a 10% change, the stock price will also change but by a greater percentage i.e. 2x = 20% (1.2 beta)

Further, for calculating Cost of equity, we can use the CAPM Approach

i.e. Re = Rf + B(Rf-RM)

Re + 0.06+ 1.2(0.085) = 16.2%

Further, the standalone standard deviation of the stock returns over 5 year period is 40% whereas that of market is only 20%.

We cannot comment on the intrinsic value of the share as that is derived with the help of dividen, cost of equity and growth (Not available).