Explanation:
We can determine if the stock is undervalued or overvalued by calculating its required rate of return using the Capital Asset Pricing Model (CAPM) and comparing it to the analyst's expected return.
CAPM required rate of return: E(R) = Risk-Free Rate + Beta × (Market Expected Return - Risk-Free Rate) E(R) = 5% + 1.8 × (8% - 5%) = 5% + 5.4% = 10.4%
Now let's calculate the fair value of the stock today based on the expected price in exactly 12 months: Fair Value = Expected Price / (1 + E(R)) Fair Value = 38.77 / (1 + 0.104) = 38.77 / 1.104 ≈ 35.1177 (or USD 35.12)
Since the calculated fair value of USD 35.12 matches exactly with the current trading price of USD 35.12, the stock is fairly valued.
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Q.54 A stock is trading at USD 35.12, and analysts expect its price in exactly 12 months to be USD 38.77. If the market expected return is 8%, the risk-free rate is 5%, and the Beta of the stock is 1.8, the stock is most likely:
A
Undervalued by USD 3.16
B
Undervalued by USD 6.81
C
Overvalued by USD 3.16
D
Fairly valued
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