Hi, Say using CAPM you calculate a return of 6% and the estimated return of the stock is 12% why is it underpriced? I’ve written in my notes that the price goes up untill it’s on the SML but why would it plot below the SML?
CAPM gives the required return on a stock with the same beta (systematic risk). If you a comparable stock has expected return of 6% and your has expected return of 12% -> the stock is underpriced. In such situation theoretically people start buying the underpriced stock, driving its price up until expected return is equal to 6%.
what, so if the return is higher than capm then it is underpriced? This doesn’t seem logical to me. is that correct?
CAPM calculates required rate of return. If your estimated return is higher than the required rate of return, the stock is underpriced. If underpriced, it plots above the SML, not below since its return is greater than expected for a given level of risk as defined by beta.
No, the opposite. If the return is lower than what you figure out for the CAPM, then it is underpriced.
amber, that is incorrect think of it this way. If CAPM tell you that the required rate of return is 10 percent and you calculate expected return to be 15 percent then the stock is underpriced by 5 percent
So for a given level of systemic risk (beta) if the expected return is greater than the return calculated using CAPM then the security is underpriced? What I don’t get is if the expected return is greater than CAPM why would it be underpriced? And inversely if the expected return is lower than what it should be (on the SML) then why is it overpriced?
I apologize, I was mixing up my vocabulary. Hope this helps: Beta E® Required Return Stock A 1.0 0.12 0.07 + (1)(0.15 − 0.07) = 0.15 Stock B 0.8 0.175 0.07 + (0.8)(0.15 − 0.07) = 0.134 Stock C 1.2 0.166 0.07 + (1.2)(0.15 − 0.07) = 0.166 Determine whether the stocks are properly valued. Answer: Stock A is under 3% (overvalued), Stock B is over 4.1% (undervalued), and Stock C is on target at 16.6%.
mambovipi Wrote: ------------------------------------------------------- > So for a given level of systemic risk (beta) if > the expected return is greater than the return > calculated using CAPM then the security is > underpriced? What I don’t get is if the expected > return is greater than CAPM why would it be > underpriced? And inversely if the expected return > is lower than what it should be (on the SML) then > why is it overpriced? let’s say required return is 6%, stock is at $94.64 and you expect that in 1 year it will be $106 (expected return of 12%). Since the stock is below $100, it’s underpriced, because the fair value is the present value of future cash flow (price in 1 year). When people see that the stock is underpriced they will drive the price up to $100 at which point it will be fairly priced.
<> ACTUALLY THE EASIEST WAY TO THINK ABOUT IT. sell side says est rtn = 10% you do CAPM and get 12% you got a higher discount rate than bob over at goldman. We know that higher disct rates = lower stock price, so the higher CAPM derived rate pulls the stock down b/c it was overpriced. thus, if CAPM > sell side estimates, the stock is overpriced and under the SML and you short it to create alpha.