A stock has a beta of 2.0. A security analyst who specializes in studying this stock expects its return to be 24%. Suppose the risk-free rate is 6 percent and the market-risk premium is 10 percent. Is the stock overvalued or undervalued relative to the market’s expectation? use the CAPM
a) What is the market expected return on stock A based on the CAPM?
(b) Is the stock overvalued or undervalued? Yes or no.
To find out whether the stock is overvalued or undervalued relative to the market's expectation, we can use the Capital Asset Pricing Model (CAPM).
(a) The CAPM formula allows us to calculate the expected return on a stock. The formula is:
Expected return = Risk-free rate + Beta * Market-risk premium
Given the risk-free rate of 6%, the market-risk premium of 10%, and a beta of 2.0, we can calculate the expected return on the stock.
Expected return = 6% + 2.0 * 10% = 6% + 20% = 26%
Therefore, the market expected return on Stock A based on the CAPM is 26%.
(b) To determine if the stock is overvalued or undervalued, we compare the expected return calculated using the CAPM (26%) with the expected return estimated by the security analyst (24%).
Since the expected return estimated by the security analyst (24%) is lower than the market expected return based on the CAPM (26%), the stock is considered undervalued relative to the market's expectation.
So, the answer is: The stock A is undervalued based on the CAPM economics model.