Undervalued/Overvalued - Portfolio Management

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rexthedog

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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.
 
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)
 
rexthedog wrote:
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)
Click to expand...
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.
 
rexthedog wrote: 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.
Click to expand...
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.
 
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.
 
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