Question

The risk-free rate of return is 2.5 percent; the expected rate of return on the market is 7 percent. Stock X has a beta coefficient of 1.3, an earnings and dividend growth rate of 4 percent, and a current dividend of $1.40. If the stock is selling for $35, what should you do based on CAPM and CDGM

Answer 1

Answer:

• Stock is overpriced/ overvalued.
• Sell if you own it.
• Don't buy if you don't.

Explanation:

Use CAPM to find the required return on the stock:

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

= 2.5% + 1.3 * (7% - 2.5%)

= 8.35%

Price based on Constant Dividend Growth Model (CDGM):

Price = Next dividend / (Required return - growth rate)

Next dividend = 1.40 * ( 1 + 4%)

= $1.456

Price = 1.456 / (8.35% - 4%)

= $33.47

Stock is selling for $35. It is overvalued. Don't buy the stock. Sell if you have the stock.