Hello All, I want to ask is it necessary that an undervalued stock relative to current market prize will always generate positive alpha in future time period. For example let say a stock currently trading at $21.4 but its intrinsic value dcf valuation is $21.7 that mean its undervalued at current prize. Required rate of return is suppose 12% and estimated 1-yr future value is $23.7 which will generate 11% return. Based on these data alpha is minus though at current prize stock is undervalued. Is it possible or not? because on CFA equity books I have read that undervalued stock will generate positive alpha?
If a stock is overvalued in relation to a particular model, the stock will generate a return below it’s required rate of return and therefore generate negative alpha. Conversely, if the stock is undervalued it should generate positive alpha. Essentially, you are looking at two models who’s assumptions do not match up instead of whether the stock in fact will generate positive or negative alpha. If the stocks estimated future value at t1 is $23.7 and r = 12%, then the stock is still overvalued at $21.4. It will plot above the security market line which tells us it should $23.7/1.12 = $21.16. However, your DCF model does not tie with the model which is estimating r = 12% (is this CAPM?). If the they tied in, and we assume the DCF model is specified correctly, you could say that r should in fact = 9.2%. Therefore, either one of the components of CAPM must be wrong 9.2% = R(f) + B(R(m) - R(f)). Conversely, if we assume that the CAPM is correct and r = 12%, then a component of the DCF model is incorrect (D1/1+.12)+(DN/1+.12^N)+Terminal Value.
Just because a stock is priced in the market lower than its calculated intrinsic value does not mean that positive alpha will be generated. In fact the stock may never price at its intrinsic value. The difficult part of being an analyst is not calculating whether a stock is priced below its intrinsic value, it’s determining if the stock will ever really reach that value and how long until it does. Even though a stock may trade below its intrinsic value the price may increase, decrease or stay the same. Remember the famous quote: “The markets can stay irrational much longer than you can stay solvent.” That is the true take-away here.