Dear All- I have a query regarding one question in Schweser. Forecast return (based on analyst estimates) of a stock is 12% while required return calculated using CAPM is 15%. Is the stock under or over valued? Please give me explanation as I am unable to comprehend the answer given in text. Thanks

The stock is overvalued based on the analyst estimate. The CAPM is telling you the stock should return 15% given it’s level of market risk but analysts only expect it to return 12% and therefore it is overvalued. An undervalued security would be expected to exceed the CAPM return, while a security that is fairly valued should, in theory, earn the CAPM return.

You might be able to see this most easily if you assign a dollar value to the expected return, say, $15. According to CAPM, its (fair) price should be $100/share ($15/$100 = 15%), but according to the analysts, its price is $125/share ($15/$125 = 12%), so it’s overpriced by $25/share (= $125 – $100).

Dcdcdc & Magician thanks a lot for your prompt response. But my doubt persists. I tell you why?

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Dcdcdc- You said-“The CAPM is telling you that the stock should return 15% given it’s level of market risk but analysts only expect it to return 12% and therefore it is overvalued.”

I say because analyst expected return is 12% and actually it should return 15% (as per CAPM) it is undervalued. Analyst has valued it conservatively.

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Magician - Your approach I could understand but can we not put it like this. Say stock price is $100. Analyst says it will fetch $112 and as per CAPM it should fetch $115. Hence analyst is undervalueing the stock

Please bear with me if I am making some foolish assumptions.

When you do a calculation like 15% of $100 is a $15 return (CAPM) and 12% of $100 is $12 (analysts), you’re assuming that $100 is the correct (i.e., fair) price of the stock. If you’re trying to determine whether the stock is overvalued or undervalued, you cannot assume that $100 is the fair price (for both analyses).

The proper approach, as I’ve mentioned, is to assume that the return ($15) is correct, and infer the fair stock price from that.

It’s the same idea as starting with the (known) cash flows on a (fixed-coupon) bond and inferring the fair price of the bond, using the required rate of return.

The terms overvalued and undervalued are relative terms, meaning that it depends on which figure your comparing to which. Typically when we speak of a security’s valuation we’re comparing our (the analyst) view of fair value to what a model or the market is currently pricing the security at. In this case we’re comparing the analyst’s expected return to the model’s expected return. If the analyst expects the stock to underperform versus what the model is calling for, we would consider the stock to be overvalued.

Again, when studying for the CFA, you’re usually taking the perspective of the analyst, trying to determine if markets are appropriately pricing securities based on what you believe to be fair value.

From the perspective of the analyst: The stock is only going to return 12% in the coming year. The model is saying that based on observable inputs, the stock requires a return of 15%. Therefore you should not buy a security with risks that warrant a 15% return but will only earn a 12% return.

You need to assume that the analyst’s expectations are true and also realize that the security is priced based on CAPM not the analyst’s expectations.

Got your point. Thanks a lot magician and dcdcdc. You were indeed very helpful

My pleasure.