CAPM Rationale

Can someone please clarify this for me because i’m yet to grasp it conceptually? If your required return (CAPM) is greater than actual return, howcome is the security overvalued? The way i think of it is the security is providing less of a return for an equal amount of risk(or beta). On a pricing basis, shouldn’t that make the security undervalued?

Thanks in advance.

Another way of saying this is that your actual return is less than your required return, right? Why is the security overvalued in this case?

I’m no CAPM expert, but would you want to hold on to a stock that provides a return less than the return you require for the amount of risk you are taking? The asset is risky, so it better pay off right? If it doesn’t expect to give you a high return you require based on it’s riskiness, sell it, it’s overvalued.

This relationship seem straightforward to me but maybe I’m not understanding what you’re confused about.

I guess when I think of a return, I relate it to a price. An overvalued security means a higher priced security which means a higher return. This might be the wrong rationale to have here but I don’t know how else to think about it.

I grasp that you’d want the security with the highest return based on it’s risk profile in any given situation. I just don’t understand how the security with the lower return is overvalued.

If you have two securities, one priced at $10, one at $15. Both have betas of 1.5. Any investor would want the $15. I just don’t understand how the $10 security is overvalued.

Again I believe i’m applying the wrong rationale for this so any help will be appreciated.

Recall the any returns that lie on the SML are in par to the market, which means they are priced appropriately. So why does actual < required = overvalued? An overvalued security no longer requires to provide the extra premiums to investors that are supposed to compensate the liquidity risk (overvalued securities are very liquid in general). Hence, when an asset’s return lies below the SML, it implies overvalue, and vice versa.

Key concep to grasp: Liquidity risk


A higher priced security might mean that it achieved a higher return in the past, but it doesn’t mean it’s going to keep giving you that return at it’s now high price. Maybe it’s overvalued now…

Like I said before, I’m no expert but this is how make sense of all this.

Say you have 2 companies, A and B. They are both $100 in the market. To keep it simple, say they are both no growth companies and pay out all their earnings as dividends which is $10 a year. Nothing about these companies leads you to believe that you will see any capital appreciation in the form of stock price growth. So right now, they both have an expected return of 10% right? If you spend the $100 and buy a share, at the end of the year you’ll have made 10% in the form of a div.

Now to CAPM. For simplicity, we’ll say that these companies have a BETA of 1. So you’re expected return is just Rf (say 3%)+ Beta* EqtRiskPremium (say 6%) = 9% for those beta 1 stocks.

So right now, I look at these and I think they are undervalued because my expected return is 10% for both when all I’m requiring for the risk is 9%. They look undervalued. I’ll buy both.

Now let’s pretend that loads of other people did the same analyis and starting buying one of the se companies. Because all these people pile in, the stock price goes up for company B, until the price is $115. Nobody took notice of company A and the price is still $100.

Now which company is undervalued/overvalued? By your logic, it’s B because it has a higher price. I think it’s A because you still expect to make more return that the risk associated with it.

Company B is now $115 but still only pays a $10 div every year. So the expected future return is now only 8.6%, which is below your required return.

As I said, I’m not an expert, but this is how I make sense of it.

Prices alone do not mean much actually…It’s only a function between market cap and shares outstanding, and manipulations are common

Prices alone do not mean much actually…It’s only a function between market cap and shares outstanding, and manipulations are common

Stock A earns a $5 return on a $50 price: 10%.

The required rate of return is 5%

A return of $5 would be a 5% return on a $100 price; stock A is undervalued.

(And when people realize that A is earning 10%, they’ll want to buy it, driving the price up to $100.)

Many thanks guys. This helps a lot.

You’re welcome.