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Common Stock Valuation, Beta and CAPM
Common Stock Valuation, Beta and CAPM
In the last lecture, we have seen that if the expected future divi-
dends grow at a constant rate g, then the current stock price P0
is given by
D0 (1 + g)
P0 =
rs g
where D0 is the last dividend paid by the company and rs is the required
rate of return on the stock. The above expression can also be written
as
D1
P0 =
rs g
where D1 is the next expected dividend.
In the above pricing formula, the required rate of return rs comes from
CAPM, i.e.,
rs = rRF + s (rM rRF )
where s is the stock’s beta.
Example 1: Thames Inc.’s most recent dividend was $2:40 per share
(i.e. D0 = $2:40). The dividend is expected to grow at a constant rate
of 6% per year. The risk-free rate is 5% and the return on the market is
9%. If the company’s beta is 1:3, what is the price of the stock today?
D0 (1 + g) 2:40(1 + 6%)
P0 = =
rs g 10:2% 6%
) P0 = $60:57
1
Example 2: A company’s stock is currently trading for $30 a share.
The stock is expected to pay a $2:40 dividend at the end of the year
(i.e. D1 = $2:40) . The dividend is expected to grow at a constant rate
of g = 5% a year. The risk-free rate rRF = 5% and the market risk
premium (rM rRF ) is 4 %. What is the stock’s beta?
Answer: First, let’s …nd the required rate of return rs :
D1 D1 $2:40
P0 = ) rs = + g ) rs = + 5%
rs g P0 $30
) rs = 13%
Now we can …nd the stock’s beta from
rs = rRF + s (rM rRF )
13% = 5% + s (4%) ) s = 2
2
To keep the current stock price at P0 = $81:54; we need
Answer: First, let us …nd the required return on the stock when com-
pany beta was 1.8:
2(1 + g)
P0old = $100 =
13% g
) 100(0:13 g) = 2(1 + g)
) 13 100g = 2 + 2g
) 11 = 102g ) g = 10:78%
After the increase in beta we know that the price dropped to P0new =
$80; which implies that
2(1 + 0:1078)
P0new = $80 =
rsnew 0:1078
2(1 + 0:1078)
) rsnew 0:1078 =
80
) rsnew = 13:55%
3
Now …nally, we can compute the new beta
new
rsnew = 13:55% = 4% + s (5%)
) new
s = 1:91
D0 (1 + g spinof f ) D0 (1 + g current )
P0spinof f = > = P0current
rsspinof f g spinof f rscurrent g current
OR
(1:06) (0:024) spinof f
> 0:04 + s (0:04) 0:06
1:08
spinof f
) 0:023 + 0:02 > s (0:04)
spinof f
s < 1:09