CAPM Mock Exam Question

CFA Level I
#1

On the CFA mock exam (first one, morning exam), Qn. 120 is about CAPM for the stock of JKU.

It says the the expected return for the stock is 15%

Then using CAPM determine if the stock is over, under or fairly valued.

According to CAPM the expected return on the stock is 12%.

I understood this to mean that the stock is overvalued as it’s return according to CAPM is less than that stated in the question.

But according to the answers the stock is undervalued as the “required” rate of return is 12% and the Expected Return (stated in the question and not determined by CAPM) is 15%.

Could somebody please help me make sense of this?

Thanks

#2

Yes undervalued if CAPM return is less than the real return.

CAPM return is the intrinsic return which means we should earn at least 12% to compensate to our risk expectation. But we will earn 15% according to market so it’s undervalued.

Imagine it on the SML line. For lower risk it will give a higher return (15 instead of 12 if it was properly priced) - hence undervalued.

#3

Let me try and break this down simply.

12%, according to the CAPM, is what the stock SHOULD return. NOT what is actually WILL return.

If the stock is projected to return 15%, it is a bargain for you because it is going to return MORE than it should.

Hence it is “undervalued”, because it is projected to return 15% when it only needs to return 12%.

#4

The 12% from the CAPM as the REQUIRED return - the return that would be fair compensation for the risk of the stock. If it is EXPECTED to return 15%, it’s a bargain - better than expected. Since there’s an inverse relationship between price and expected return, this must mean that it’s UNDERVALUED.

#5

Another way to think of it is that if it’s priced at $100/share and returns its expected 15%, that’ll be a $15 increase. If it returned that same $15 increase as its required (12%) return, then it should have been priced at $125/share (because $15/$125 = 12%). Thus, it’s underpriced by $25/share.