Expected Return vs CAPM.

[Thammer]

Hi,

According to Shweser:

If expected return by the analyst is 10% and CAPM says 12%. The stock is overvalued.

My thoughts:

If you use you use 10% instead of 12% in a DCF model you will get a higher stock value. If you discount a cashflow at a lower rate its value will be higher.

Eg:

Stock value based on r = 10% (g =5%): 1.05/0.10-0.05 = 21

Stock Value based on r = 12% (g= 5%): 1.05 / 0.12-0.05 = 15

So to me this looks like the CAPM r of 12% is undervalued, not overvalued? What am I missing or is Schweser wrong?

[studyguy18]

My simple interpretation:

CAPM will give you a required return on equity. If the expected return is less than this amount, then the investment will not adequately compensate you for taking on the equity risk (i.e. you are paying too much to hold the risk). Therefore it is overvalued.

[thanhnguyen504]

apply the security market line concept here. the CAPM is the line, and anything above it is under priced, anything below it is overpriced

[yx5353]

Here’s an easy way to think of it

The expected return of the stock is 10%, but CAPM is telling you that it’s 12%

This means that your stock should increase by 12% instead of 10%, and thus has a higher price point and hence overvalued

For example, let’s say the stock is $10 and expected to rise 10% until $11. But CAPM is saying that it should gain 12%, not 10%. So the “fair price” should trade lower at $9.8, allowing it to gain 12%. Since $10 is greater than a fair price of $9.8, the stock is overvalued.

[Thammer]

@yx5353

Here’s an easy way to think of it

The expected return of the stock is 10%, but CAPM is telling you that it’s 12%

This means that your stock should increase by 12% instead of 10%, and thus has a higher price point and hence overvalued

For example, let’s say the stock is $10 and expected to rise 10% until $11. But CAPM is saying that it should gain 12%, not 10%. So the “fair price” should trade lower at $9.8, allowing it to gain 12%. Since $10 is greater than a fair price of $9.8, the stock is overvalued.

Thank you all for your replies. Yx5353, great example, that clears it up! Appreciate it.

[Thammer]

[quote=“Thammer”]

@yx5353

Here’s an easy way to think of it

The expected return of the stock is 10%, but CAPM is telling you that it’s 12%

This means that your stock should increase by 12% instead of 10%, and thus has a higher price point and hence overvalued

For example, let’s say the stock is $10 and expected to rise 10% until $11. But CAPM is saying that it should gain 12%, not 10%. So the “fair price” should trade lower at $9.8, allowing it to gain 12%. Since $10 is greater than a fair price of $9.8, the stock is overvalued.

Thank you all for your replies. Yx5353, great example, that clears it up! Appreciate it.

I guess I can think of it the other way around to.

CAPM: 10%

Expected Return: 13%

The stock is undervalued, right?

[Mercutio]

CAPM tells you how much return you should get for the amount of risk you take (via beta). If you expect a return on your investment that is higher than the appropriate return for the risk, than that is good news and the stock is undervalued for your expectation of the return you will get, and vice versa.

[yx5353]

Yes the stock is undervalued as you have a lower price point than what is implied by the CAPM. Just reverse the example : ). Glad that was helpful