Question

An investor expects a share to pay dividends of $3, $3.2, and $3.15 at the end of Years 1, 2 and 3, respectively. At the end of the third year, the investor expects the shares to trade at $70. The required rate of return on the shares is 10%. If the investor’s forecasts are accurate and the market price of the shares is currently $70, the most likely conclusion is that the shares are: A. overvalued. B. undervalued. C. fairly valued.

Answer 1

The share's expected cash flows (dividends and sale price after three years) when discounted at the required rate of return of 10%, should sum up to the share's fair price at present. A comparison of the current market price with the fair price should tell investors if the share is overvalued, undervalued or fairly valued.

Fair Price = 3 / 1.1 + 3.2 / (1.1)^(2) + 3.15 / (1.1)^(3) + 70 / (1.1)^(3) = $ 60.33

As the current market price of $ 70 is more than the current fair price, the share can be conlcuded to be overvalued.