Undervalued/Overvalued - Portfolio Management

CFA Level I
#1

With respect to CAPM, I am unsure of which angle to take when deciding whether an asset is over or undervalued.

Say for example, CAPM states 16% return, but market expected return is 20%

Is the asset overvalued? (Because the market says 20 and your research on CAPM fairly values at 16. Therefore 20>16)

Is the asset undervalued? (Because Market says 20, but your CAPM is only fairly valued at 16. Therefore 16 <20)

Thanks for any clarifcation.

#2

(see second post)

#3

The EOC chapter Question says:

Analysts have estimated returns of an asset to be greater than the expected returns generated by CAPM should consuder asset to be:

Over

Under

Correctly valued

Correct answer: B Undervalued.

Surely this goes against your comment above?

“If the expected return using the CAPM is higher than your required return, the security is undervalued and you should buy it.” (above)

#4

In this case, the market has undervalued the asset (using your result from the CAPM as the benchmark).

Consider the following asset with a price target of $50:

-The market expects a 20% return, so the asset must be priced at $41.67 (50/(1+20%)).

-You expect a return of 15%, so you value the asset at $43.48 (50/(1+15%)).

Here, you’re assuming the market’s expected return is factored into the price, but that you’re expected return is the RIGHT one.

Maybe I’ve only served to confuse you further - if so, I apologize.

#5

I find this stuff to be visualized best if I create an example with specific numbers.

A stock is estimated to return $10/share in a year; its current market price is $100/share. The (fair) expected return according to CAPM is 5%.

So, the estimated return is 10% (= $10 / $100), and the CAPM return is 5%.

For the stock to return 5% (fair, according to CAPM), the price would have to be $200/share ($10 / $200 = 5%). As the current price is $100/share, the stock is undervalued.

The key to understanding this is the realization that _the return in dollars is unchanged _; what changes is the initial price.

#6

Thanks S2000 & Cgottuso that makes sense.

In essence in this regard we use CAPM as the actual return.

If estimates > CAPM, undervalued.

If estimates < CAPM, Overvalued.

#7

My pleasure.

Good to hear.