Question

You are analyzing a common stock with a beta of 0.8. The risk-free rate of interest is 3 percent and the market risk premium is 10 percent. If the stock's return based on its market price is 11 percent, is the stock over, under or correctly valued

Answer 1

The stock is correctly valued

Explanation:

The formula for SML return can be given as:

SML return = Risk free rate + (beta*market risk premium )

Risk free rate = 3% = 0.03

Beta =0.8

market risk premium =10% = 0.1

SML return = 0.03+(0.8*0.1) = = 0.11 = 0.11 * 100 = 11%

Stock return based on market price = 11%

Since SML return = Stock return based on market price = 11% , the stock is correctly valued

Answer 2

The stock is correctly valued.

Explanation:

Whenever the expected return is lower than the required return; the stock is said to be undervalued, when the expected return is higher than the required return; the stock is said to be overvalued, and when the expected return is equal to the required return; the stock is said to be correctly valued .

The required rate of return = Risk free rate+Beta*Market risk premium

The required rate of return = 3 + (0.8*10) = 11%

From the above calculation, the required rate of return rate is 11%, which is equal to the stock's return provided in the question, therefore, the stock is correctly valued .