Recalculating stock using the pe ratio model

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Reference no: EM1366726

We will use both the CAPM and the Constant Growth Model (CGM) to arrive at IBM's stock price. To get started, let us do the followings.

1. Determine an estimate of the risk free rate of interest. Click on skip intro and click on Market Data to find the ten year Treasury bond rate. Use this interest rate as the risk-free rate. You also need a value for the market risk premium. We will use an assumed market risk premium of 7.0%.

2. Using recent information found on the Quicken.com website and copied to this document, find an estimate of IBM's beta (à?). Use Quicken's stock symbol lookup function to get IBM's stock symbol. To get the à?, go to "Fundamentals". While there, also obtain IBM's current annual dividend and its 3-year growth rate or g.

3. Given above, use the CAPM to calculate IBM's required rate of return or ks.

4. Use the CGM to find the current stock price for IBM. We will call this the theoretical price or Po.

5. Go back to Quicken, and obtain IBM's current stock quote, or P. Compare Po and P. Do you see any differences? Can you explain what factors may be at work for such a difference in the two prices? This section is especially important- so you may want to think about the answer before answering the question. Explain your thoughts clearly.

6. Now assume the market risk premium has increased from 7.0% to 10%; and this increase is only due to the increased risk in the market. In other words, assume krf and stock's beta remain the same exercise. What will the new price be? Can you explain what happened?

7. Recalculate IBM's stock using the P/E ratio model and the needed info found at Quicken.com. Explain why the present stock price is different from the price arrived at using CGM.
P/E= Price per share/ Earnings per share
Appropriate Stock Price= Industry P/E Ratio*EPS

Here is something far more important to consider. The value for k risk-free is based upon the interest rate for a Ten-Year U.S. Treasury Bond. Given the U.S. Government's annual operating deficits, the challenges and costs of the war on terrorism, its debt and debt service load and the impending wave of Social Security liabilities as "boomers" retire, is it possible that the standard formula for k risk-free may one day prove to be untenable?

Reference no: EM1366726

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