Question

Suppose you are an investment advisor in an investment bank. A potential client is interested in Apple Inc’s stock. However, this client is very sensitive to investment risk. How will you explain Apple’s risk to your client if you use the Yahoo Finance Webpage as information resource? Your client might ask you whether Apple’s stock is over-priced now. Since Apple just announced its new iPhone and i-watch products, you anticipate its sales revenues and dividend will grow at 20% in next 4 years and after year 4 the dividend growth rate will remain 5% constantly. Apple paid $9.68 per share dividend last year. You see the T-bill yield is 2% currently and SP500 return is 10.8%. What is the fair value of Apple’s stock? If your client plans to buy and hold Apple’s stock for two years and sell it two years from today, what will be the selling price?

Answer 1

As per the Yahoo Finance web page, Apple's Stock has a beta of 0.99 which implies that the changes in return for Apple stock are 0.99% of the % change in returns of the S&P 500. This means that the Apple Stock is almost as risky as an investment in the S&P 500 index.

T-Bill Yield = 2 % = Risk-Free Rate = Rf and Market Return = Rm = S&P 500 returns = 10.8 %

Using CAPM, Required Return on Apple Stock = Rf + Beta x (Rm - Rf) = 2 + 0.99 x (10.8 - 2) = 10.712 %

Current Dividend = D0 = $ 9.68 and Initial Grow Rate = 20 %

Therefore, D1 = D0 x 1.2 = 9.68 x 1.2 = $ 11.616, D2 = D1 x 1.2 = 11.616 x 1.2 = $ 13.9392

D3 = D2 x 1.2 = 13.9392 x 1.2 = $ 16.72704 and D4 = D3 x 1.2 = 16.72704 x 1.2 = $ 20.07245

Perpetual Long-Term Growth Rate = 5 %

D5 = D4 x 1.05 = 20.07245 x 1.05 = $ 21.07607

Therefore, Current Stock Price = PV of D1 to D4 + PV of Terminal Value of Perpetual Dividends = 11.616 / 1.10712 + 13.9392 / (1.10712)^(2) + 16.72704 / (1.10712)^(3) + 20.07245 / (1.10712)^(4) + [1/(1.10712)^(4)] x [21.07607/(0.10712-0.05)] = $ 293.148

Current Stock Price = $ 174.57

As the market stock price is below the firm's estimated intrinsic stock price, the stock can be considered to be underpriced. An underpriced stock makes for a good buy.

Selling Price after 2 years = Present Value at t=2 of remaining dividends = 16.72704 / (1.10712) + 20.07245 / (1.10712)^(2) + [1/(1.10712)^(2)] x [21.07607/(0.10712 - 0.05)] = $ 332.5163