Keith holds a portfolio that is invested equally in three stocks (Wd = Wa = Wi = 1/3). Each stock is described in the following table:
Stock
Beta
Standard Deviation
Expected Return
DET
0.7
25%
8%
AIL
1.0
38%
10%
INO
1.6
34%
13.5%
An analyst has used market and firm-specific information to make expected return estimates for each stock. The analyst's expected return estimates may or may not equal the stocks' required returns.
The risk-free rate (Rf) is 6% and the market risk premium (Rp) is 4%. Use the following graph with the security market line (SML) to plot each stock's beta and expected return.
A stock is in equilibrium if its required return ___________ its expected return. In general, assume that markets and stocks are in equilibrium (or fairly valued), but sometimes investors have different opinions about a stock's prospects and may think that a stock is out of equilibrium (either undervalued or overvalued). Based on the analyst expected return estimates, stock INO is ___________, stock AIL is equilibrium, and stock DET is _________.
Landon Stevens is evaluating the expected performance of two common stocks, Furhman Labs, Inc., and Garten Testing, Inc. The risk-free rate is 5.2 percent, the expected return on the market is 12.2 percent, and the betas of the two stocks are 1.4 and .9, respectively. Stevensâs own forecasts of the returns on the two stocks are 16.40 percent for Furhman Labs and 11.20 percent for Garten.
1.
Calculate the required return for each stock. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places. Omit the "%" sign in your response.)
Stock
Required Return
Furhman Labs
%
Garten Testing
%
2.
Is each stock undervalued, fairly valued, or overvalued?
