Equity HPR Question only, beginning, expected, investor

amqata

EOC Shweser
An investor buys a stock he determines to be underpriced in the market. He estimates the required return on the stock to be 14%. If he expects the stock will still be underpriced at the end of the year, the expected holding period return:
A. Is greater than 14%
B. Is less than 14%
C. Could be less than, equal to, or greater than 14%
As per Schweser the answer is C:
“The HPR depends on how underpriced the stock is at the end of the year VS the beginning. The only thing we know for sure is that if the stock is expected to be properly valued at the end of the year, the expected HPR  14%”
I thought the answer is A, since the required return on the stock is expected to be 14% and the stock is undervalued wont the HPR always be greater than 14% (i.e. even greater that the HPR if it was properly valued)
HPR =( P1- P0)/P0 ( ignore dividends). You will always realize atleast the required return on the stock from capital appreciation.

mnieman

Assume that the stock’s fair value is 100. If the expected return is 14%, the fair value next year is 114. Assume further that the stock is currently undervalued at 90.
“The only thing we know for sure is that if the stock is expected to be properly valued at the end of the year, the expected HPR  14%”
So, in order for the stock to be properly valued at the end of the year, the price has to go up to 114. Since (114-90)/90  14%, the expected HPR has to be  14%.

sabina

This is just silly logic. If the stock is fairly priced HPR14% . OK fine.
And If stock is NOT fairly priced? HPR could be anything right? either  14 or
So basically its just an unsupported conjecture.

ohai

I see your point, but I still dont understand what schweser says about
“The only thing we know for sure is that if the stock is expected to be properly valued at the end of the year, the expected HPR  14%”

franzino

Required return has absolutely nothing to do with an actual holding period return post fact.
The statement is trying to trick you by putting in 3 terms each of which has no direct relationship to any other:
Holding Period – after the fact, based on actual prices
Expected Price – Analysts opinion
Required Return – based on perceived risk
Tell me what any of them has to do with any other?

svgleeson

You don’t know how big the discount was. How much was it underpriced (16% discount, 2% discount)? The required return is not a guarantee.

Kapie

He mentioned that the stock is underpriced and in the one year it was still underpriced.
We dont know where the stock price went. Did it go above, below or was equal to the same price it was before? Thus we cant conclude what the expected holding return will be.