Question

Let's assume that you're thinking about buying stock in West Coast Electronics. So far in your analysis, you've uncovered the following information: The stock pays annual dividends of $4.74 a share indefinitely. It trades at a P/E of 10.1 times earnings and has a beta of 1.14. In addition, you plan on using a risk-free rate of 4.00% in the CAPM, along with a market return of 11%. You would like to hold the stock for 3 years, at the end of which time you think EPS will be $9.77 a share. Given that the stock currently trades at $75.41, use the IRR approach to find this security's expected return. Now use the dividend valuation model (with constant dividends) to put a price on this stock. Does this look like a good investment to you? Explain.

Answer 1

Info:

Stock Price Today = 75.41

PE Ratio = 10.1

Annual Div = $ 4.74

Beta = 1.14

Rf = 4%

Rm = 11%

EPS3 = 9.77

SML Ret or CAPM Ret = Rf + Beta ( Rm - Rf )

Rf = Risk free ret
Rm = Market ret
Rm - Rf = Risk Premium
Beta = Systematic Risk

Particulars	Amount
Risk Free Rate	4.0%
Market Return	11.0%
Beta	1.1400
Risk Premium ( Rm - Rf)	7.00%

Beta Specifies Systematic Risk. Systematic risk specifies the How many times security return will deviate to market changes. SML return considers the risk premium for Systematic risk alone.Where as CML return considers risk premium for Total risk. Beta of market is "1".

SML Return = Rf + Beta ( Rm - Rf )
= 4 % + 1.14 ( 7 % )
= 4 % + ( 7.98 % )
= 11.98 %

Price after 3 Years = EPS3 *PE ratio

= $ 9.77 * 10.1

= $ 98.68

Expected Ret is the Ret at which PV of Cash Inflows are equal to PV of Cash Outflows.

Year	Cash Flow	PVF/PVAF @ 15 %	PV of Cash Flows	PVF/PVAF @16 %	PV of Cash Flows
1-3	$                        4.74	2.2832	$                          10.82	2.2459	$                        10.65
3	$                      98.68	0.6575	$                          64.88	0.6407	$                        63.22
PV of Cash Inflows			$                          75.71		$                        73.87
PV of Cash Oiutflows			$                          75.41		$                        75.41
NPV			$                            0.30		$                         -1.54

IRR = Rate at which least +ve NPV + [ NPV at that rate / Change in NPV due to Inc of 1% in Int Rate ] * 1%
= 15 % + [0.3 / 1.84 ] * 1%
= 15 % + [0.1609 ] * 1%
= 15 % + [0.1609 % ]
= 15.16%

Bond Price using DIv discount Model:

Year	Particulars	Cash Flow	PVF @18 %	Disc CF
1	D1	$      4.74	0.8475	$              4.02
2	D2	$      4.74	0.7182	$              3.40
3	D3	$      4.74	0.6086	$              2.88
3	P3	$   98.68	0.6086	$           60.06
Price				$           70.37

Fair Price is $ 70.37, Actual Price is $ 75.41. As Fair Price < Actual Price. Stock is over priced.