Should be a simple question but I got confused over it…

The vignette says:

Based on her extensive analysis, she determines that her expected return on the stock, given Taylor’s risks, is 10%. In applying the capital asset pricing model (CAPM), the result is a 12% rate of return.

Now the question asks if the stock is under/overvalued.

I thought since the CAPM (based on the market value of the stock) is yielding a higher rate of return, that means the stock is trading below its intrinsic value (given the analyst’s estimate) and hence it is undervalued. Using the growth models, the value of a stock is inversely proportional to its required rate of return.

But the answer is as follows:

Since the required return (12%) as determined by CAPM is greater than Lear’s expected return (10%), then Taylor’s stock is overvalued.

Whenever you have a lower expected return compared to required rate of return the underlying investment will be overvalued. The reason why it’s overvalued because your assuming that the actual intrinsic value is well below its required return therefore it’s overvalued.

if you had valued the cashflows at a 12% expected return - you would have landed up with a LOWER value than if you evaluated those same cashflows at 10% return (which is what you did). So your value with the 10% return is OVERVALUED.

The Stock Price is 100, based on investors required return is 12%.

However, you find out that the return you can achieve is only 10%. Meaning that if you still pay 100 and only receives 10%, you pay to much, i.e. the stock is overvalued.