# Understanding Theoretical Stock Prices

Find an estimate of the risk-free rate of interest (krf). For the value, go to Bloomberg.com: Market Data and use the "U.S. 10-year Treasury" bond rate (middle column) as the risk-free rate. You also need a value for the market risk premium. Use an assumed market risk premium of 9.00%.

Download the XYZ Stock Information which is attached.

Using the information from the XYZ Stock Information document, record the following values:

XYZ's beta

XYZ's current annual dividend

XYZ's 3-year dividend growth rate (g)

Industry P/E

XYZ's EPS

With the information you recorded, use the CAPM to calculate XYZ's required rate of return (ks).

Use the CGM to find the current stock price for XYZ. We will call this the theoretical price (Po).

Now use the XYZ Stock Information that is also attached to find XYZ's current stock quote (P). Compare Po and P and answer the following questions:

What are the differences if they are any?

What factors may be at work for such a difference in the two prices?

Now assume the market risk premium has increased from 9.00% to 12% and this increase is due only to the increased risk in the market. In other words, assume the krf and the stock's beta remain the same for this exercise.

What will the new price be? Explain.

Recalculate XYZ's stock price using the P/E ratio model and the needed info found in the XYZ Stock Information file.

Why is the present stock price different from the price arrived at using CGM (Constant Growth Model)?

If you used Microsoft Word to arrive at your answers, then you must provide an explanation of the formulas and calculations.

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#### Solution Preview

Find an estimate of the risk-free rate of interest (krf). To obtain this value, go to Bloomberg.com: Market Data and use the "U.S. 10-year Treasury" bond rate (middle column) as the risk-free rate. In addition, you also need a value for the market risk premium. Use an assumed market risk premium of 9.00%.

Answer: 1.69%

Using the information from the XYZ Stock Information document, record the following values: ?XYZ's beta (ß) ?XYZ's current annual dividend ?XYZ's 3-year dividend growth rate (g) ?Industry P/E ?XYZ's EPS

Answer:

1. XYZ's beta (ß) = 1.64

2. XYZ's current annual dividend = $0.8

3. XYZ's 3-year dividend growth rate (g) = 8.2%

4. Industry P/E = 23.2

5. XYZ's EPS. = $4.87

With the information you recorded, use the CAPM to calculate XYZ's required rate of return (ks).

Answer: Under CAPM:

Ks = KRF + (market Risk Premium)

Ks =1.69 + 1.64(9)= 16.45%

Use the CGM to find the current stock price for XYZ. We will call this the ...

#### Solution Summary

The expert examines understanding theoretical stock prices.