Equity Valuation Models - CAPM & CGM
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By walking through a set of financial data for XYZ, this assignment will help you better understand how theoretical stock prices are calculated and how prices may react to market forces such as risk and interest rates. You will use both the CAPM (capital asset pricing model) and the constant growth model (CGM) to arrive at XYZ's stock price.
Please show all work, including formulae and calculations used to arrive at financial values.
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 7.5%.
Download the XYZ Stock Information by clicking the link.
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 to find XYZ's current stock quote (P).
Compare Po and P and answer the following questions:
Are there any differences?
What factors may be at work for such a difference in the two prices?
Now assume the market risk premium has increased from 7.5% to 10% 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)?
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Solution Summary
Detailed calculations including CAPM and CGM. Explores strengths and limitations of both valuation models.
Solution Preview
See attached file for proper format.
The following values are all taken from the given XYZ overview page:
XYZ's beta = 1.64
XYZ's current annual dividend= $0.80/share (1.05% yield)
XYZ's 3-year dividend growth rate (g)= 8.2%
Industry P/E= 23.2
XYZ's EPS= 15.65
Introduction
Current stock market volatility provides a long-term investor many opportunities to find mispriced securities. Fundamental analysis provides a basic method by which to identify such values. The basic difficulty in this type of analysis lies in defining what type of fundamental data comprises information, then deciding on what assumptions to manipulate this information into a usable stock valuation. Fundamental analysis can be divided into two primary categories: quantitative and qualitative, (McClure, 2011). Qualitative elements attempt to capture the quality or character of company's savvy corporate leadership, effective operations management , public image, etc. Quantitative factors, however, focus on measurable (typically numerical) values assets, liabilities, cash flows, equity, etc. While the former cannot be simply discounted, the latter of the two offers considerably more precise methods by which to measure the valuation of a company. The accuracy of these methods differs in the models and their underlying assumptions.
Market Assumptions
Several underlying economic assumptions are common across valuation models. The two most important are the idea of risk free rate of return (RF) and a market risk premium (RM). The first given, RF, defines the basic time-value of money and typically uses a "zero coupon government bond matching the time horizon of the cash flow being analyzed," (Damodaran, nd). The following valuation ...
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