I am trying to wrap my head around this…maybe schweser is confusing me…if the expected return is greater than the required return then the security is undervalued…and if the required return is greater than the expected return the security is over-valued…the SML essentially graphs the results of CAPM and therefore I would assume represents the required return? So by this logic if the SML line represents the required return and is below the expected return then it is under-valued…correct? So essentially where do we get the expected return from since CAPM gives us the required return and also why areas they used expected return and required interchangeably when talking about CAPM…MAGICIAN 2000 would easily destroy this question!!!
CAPM predicts that the expected return would be equal to the required return. The expected return is greater if a security is expected to earn above it’s cost of capital.
For example, two banks with the same exact risk and market cap, but one is expected to earn $1.20 EPS, while the other is expected to earn $1.40 EPS. The CAPM based on their betas (assume they have the exact same risk exposure), predicts that banks of that risk structure should give you $1.30 EPS over the next year. Therefore, one is above the SML, and the other is below it. Both will converge towards the SML given enough market time, and you will realize positive or negative alpha, in addition to their required returns.
Hope this makes sense.
not particularly but thanks for the response…convergence isnt guaranteed so from that point confused things for me…I think I understand in simple terms…the SML represents the required rate of return so if your expected return is greater then the security is undervalued because given the level of risk you are taking you should only be earning lets say 1.3 in your example but you are expected to earn 1.4.
Look at this scope:
The price you pay for a security is the cost of the right to receive its future cash flows (dividends), ok?
So the price here will generate a determined rate of return. If the price goes up, the return will go down, and viceversa.
Knowing how the price moves when returns move (after SML and CAPM analysis) gives you the answer to know if the security is undervalued or overvalued.
Example: If the CAPM model say that the required rate of return of Samsung Inc. is 12% and it is actually returning 15%, is it undervalued or overvalued? In this case would be undervalued right?, because if the actual return is higher than the model prediction, so the price MUST be lower in order to generate those elevated returns, so it is undervalued.
I think this is a nice way to at least not confuse with the conclusion and have a correct answer for the exam.
If the security is undervalued (or overvalued), then the only way to realize that excess return or loss, is a convergence towards its SML.
If a stock is undervalued because it is expected to earn FCFE higher than it’s COE (for example), then you will only realize that excess return if the market pulls the secuirty price back in line with your expected returns on equity. If the market decides that it’s fairly valued, and the stock never pays a dividend, then you will never realize a return over the currently required according to its CAPM price. Does that make more sense?
Think of it this way: The required return will be determined from the current stock price, if you think about the gordon growth model. The expected return will be derived from some intrinsic value (estimated PV FCF model, etc). If the estimated intrinsic value is greater than the current stock price, your current price security is undervalued and you should buy it because you expect the price to reach the intrinsic value. The intrinsic value is what you “expect” the price to be. if you expect it to be greater then the current price (which gives you a required return), your expected return must be greater than your required return and thus must mean your security is undervalued.