Stock Valuation

 Stock Valuation

Stock valuation refers to the process and procedure of determining the intrinsic value of the stock(s) of common shares. The determination of intrinsic value is important in making purchase or sell decision regarding the stock of the market. For instance, if the stock is trading at high price than its actual value, then the stock(s) should be sell if have, and if the stock(s) are undervalued/underprices means trading at low price than their actual value then there should be purchase decision. Thus, the valuation of stock is important to take purchase or sell decision.

Capital Asset Pricing Model

Capital asset pricing model (CAPM) presented by Sharpe (1964) is an asset pricing model that is used to determine the value of the stock-whether the stock is overvalued/underpriced or undervalued/overpriced. CAPM is also known as single factor model which assumes that there is only one factor that is market factor which can affect the stocks prices and returns of stock(s). In other words, CAPM estimate expected return on asset(s) based solely on systematic risk also known as beta in CAPM, of the asset. In other word, the movement of stock follow the trend in overall market such as if the market return is falling the stock price would be also falling, and if there is an increasing trend in the overall market, then the stock price will move in upward direction. Thus, according to CAPM only systematic risk is priced and the only source of systematic risk is market return which is the return of market index and can be calculated through the market index prices (daily, weekly or monthly) through the following formula;

                                           Return = In (p₁/p₂)

In addition, the only systematic risk beta is the risk premium which should be demanded by the investor(s) for taking risk). This project is going to determine the value of two stocks through CAPM. The objective of this project is to determine whether the stocks are undervalued or overvalued. CAPM has been employed to accomplish the main objective of the study.

The study has used two stocks listed on S&P 500 index, Apple Inc. and Microsoft Corp (MSFT), and S&P 500 index as market index used to calculated market return. Monthly prices of both stocks as well as S&P index has been collected from Yahoo Finance from 1/1/2000 to 1/1/2017 for a total of 18 years with total observations 216. Stock returns are treated as dependent while market return has been treated as independent factor for regression in order to obtain beta coefficient. And T-bill rate has been treated as risk free rate estimation of expected return of stock(s). Beta which is the systematic risk associated with market return has been calculated through regression. Whereas, expected return for both the stocks has been computed through CAPM. Further, the project compares the stock returns to observe whether they trading at their intrinsic value, or undervalued/overvalued. This project is further divided into sections to explain the important parts of this project. The

Required Rate of Return and Beta

Required rate of return also known as hurdle rate denotes to the minimum return that has been accepted by the investor(s) when they hold the stock(s) of the company as compensation for bearing the risk which is connected with holding the stock(s). As risk is directly associated with return; thus, riskier stocks have higher return than others with less risk.  RRR could be computed through Gordon Growth model as well as CAPM. CAPM has been usually used to compute RRR for those stocks by investors that do not pay dividend. CAPM use beta for computing RRR; thus, beta is used for measuring the risk of asset/stock(s). The stock(s) with high beta than 1 are considered riskier than the overall market. And stock(s) with beta less than 1 are less riskier than overall market.  In this case, the beta for both stocks are more than one which means that both the stocks are more risky than the overall market (S&P index).  Further, RRR is the excess return that investors demanded for the risky stock(s). In this case, stocks have higher return because of having high risk.

Limitation of CAPM

According to CAPM there is only one factor that affect the prices of asset(s)/stock(s), while in reality, stock market is very complex and because of the complexity of stock market it is not possible to explain the variation in stock prices based on only one factor. There are other factors that affect the price and return of stocks traded in market.