Undervalued Stock Example - Undervalued Stock (An...

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Undervalued Stock (An Investment Located Above the SML Line) Consider company Z. The price of a share of company Z stock is P 0 Z = $10 and the company is expected to pay D = $1 annual dividend-per-share in perpetuity. Cash flows: The beta of company Z stock is β Z = 0.5. The risk free rate is R f = 4% and the expected return on the market portfolio equals E(R m ) = 10%. Is this stock under or overvalued? 1. Method I: use the CAPM to find the discount rate and then discount all future cash flows from this investment: The PV of future cash flows is greater than the price of the stock today, allowing the investor to buy an investment for $10 even though it is worth 14.29 (buying this stock is a positive NPV investment!). The investor should buy this stock since it is undervalued . This is the most intuitive among the three methods, since it directly compares the value of the investment to its current price. 2.
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This note was uploaded on 11/01/2011 for the course BUSINESS FIN301 taught by Professor Andrew during the Fall '10 term at University of Alberta.

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Undervalued Stock Example - Undervalued Stock (An...

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