CFAI Book 6, RD.68, PG. 580, Q16 CAPM is 10.9%, forecasted return is 9%. I always get this confused. According to the book, since the forecasted return is below the CAPM, it is overvalued. Why is it overvalued? If it lies below SML shouldn’t it be undervalued? Thanks!
what do you use the rate of return for? you discount cash flows at it… 10.9 % will give you a lower number, when compared to 9% for the discount rate. so the 9% is overvalued.
As always, thank you very much!
One easier way to remember is CAPM return is based on stock’s beta i.e. stock’s systematic risk. CAPM return is the return that should come out coz of the risk involved. Forecasted Return is based on how the scenario looks like and what will probably be the outcome. When actual(forecasted) < calculated(capm), the stock is overvalued. I myself forget SML above and below thing so cant really help with that.
Even in L1 I would always confuse the above/below the SML concept. Guess it is just one of those things that never sticks even after hours and hours of studying. I think the discounting example, provided by cpk123, will make it easier to understand. Whenever I see this problem, going to just bring out a simple discounting example. 1/(1+r) and see if the forecasted return is above or below the CAPM return.