Your broker has advised you that he believes that a stock is going to rise from

Question

Your broker has advised you that he believes that a stock is going to rise from $20 to $22.75 per share over the next year with no dividend payment. You know that the annual return on the S&P 500 has been 11.25% and the 90-day T-bill rate has been yielding 4.75% per year over the past 10 years. If beta for this stock is 1.25, will you purchase the stock?

A) Yes, because it is overvalued B) No, because it is overvalued C) No, because it is undervalued D) Yes, because it is undervalued E) Yes, because the expected return equals the estimated return

Explanation / Answer

A) Yes, because it is overvalued.

Estimated return = {(22.75 – 20) / 20} × 100 = 13.75%

Expected return = 11.25%

The stock is overvalued, since the estimated return is higher than expected return.

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