If capm is greater than the expected return the security is overvalued… How does that make sense because if the security return is less than what capm would predict, it means that it Is undervalued and has not yet reached it’s full potential.
When you increase a company’s cost of capital you are reducing its value. CAPM is calculating the return required for a given amount of risk. If that amount of risk requires a higher return, it will reduce the company’s value.
The CAPM gives the investor the required return on an equity investment based on its various inputs. Beta, Risk free rate and the return on the market. If the expected return of the security is less than the return required by CAPM this security would be overvalued and therefore should be sold or an investor should maintain a short position. If the expected return is greater than the return required based on the CAPM an investor would then go long the security because the stock expects to return an amount greater than required based on the risk
Individual cash flows are DISCOUNTED at the rate of return to arrive at the Value of the company. If RETURN increases - you would have a lower value. So if Expected Return < CAPM Return -> based on the Expected Return you would have a higher value for a series of Cash flows. This would mean that you would end up with a higher valuation (OVERVALUED) when compared to the CAPM return. [Very similar in concept to Higher Interest rate - lower value of BOND].
@cpk123 your comment is legendary, thank you
CAPM gives us the required return.
Expected Return = Required Return + [(V0 - P0)/P0]
If Required Return > Expected Return, then V0 must be < P0 (since (V0 - P0)/P0 must be <0 for the equation to work)
If V0 < P0, the stock is overvalued