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NISM Certifications · NISM-Series-XV: Research Analyst · Fundamentals of Research

An analyst builds three scenarios for a stock's value: Rs 600 in the bull case with probability 0.25, Rs 480 in the base case with probability 0.50, and Rs 280 in the bear case with probability 0.25. The current price is Rs 440. What is the probability-weighted value, and is the stock undervalued relative to it?

The probability-weighted value is Rs 460 (150 + 240 + 70). Because the current price of Rs 440 is below this, the stock appears undervalued. A simple average of the scenarios would ignore the unequal probabilities and give a wrong figure.

  1. ARs 460; yes, the price is below the weighted valueCorrect
  2. BRs 453.33; yes, the price is below the weighted value
  3. CRs 460; no, the price is above the weighted value
  4. DRs 480; no, the price equals the base case

Explanation

Expected value = 0.25x600 + 0.50x480 + 0.25x280 = 150 + 240 + 70 = 460. Since 440 is less than 460, the stock looks undervalued. Using a simple average of the three values gives 453.33, which ignores the probabilities.

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