Overvalued security

The Security Market Line says what return a security ought to earn, given how much market risk it carries. Feed in its beta and the line gives you a number.

Now compare that with what the security is actually expected to return. Two things can happen.

If the expected return is below the line, the security is overvalued. You are being offered less than the risk deserves. The price is too high for the return on offer.

If the expected return is above the line, it is undervalued instead.

In theory, under market equilibrium, every asset should plot exactly on the line. Anything off the line is a mispricing — and for an active manager, an opportunity.

The test (section 16.9). Theoretically, under conditions of market equilibrium, all assets and all portfolios of assets should plot on the SML. Using that, undervalued, overvalued and fairly valued securities can be identified. Any security with an estimated return that plots above the SML is undervalued; any security with an estimated return that plots below the SML is overvalued.

The workbook's own numbers. Take a stock with beta 1.2, a risk-free rate of 8% and a market risk premium (Rm − Rf) of 14%. Under ideal conditions the stock should generate:

8% + (1.2 x 14%) = 24.8%

The workbook then supposes the stock is currently expected to generate 26%, which plots above the line, and is therefore undervalued. Reverse it and the same machinery diagnoses the opposite case: an estimated return of, say, 22% against the same 24.8% requirement plots below the line and the stock is overvalued.

Exhibit 16.6. The workbook's plot shows security C above the SML — a higher expected return than its market risk warrants, so undervalued — and security D below the SML, with a lower expected return for a given level of risk, so overvalued.

The related use of the SML (section 16.8). Once an investor knows an asset's systematic risk, the beta can be plotted on the x-axis and the perpendicular to the SML reads off the expected return directly. Over-valuation is simply the gap between that reading and the return actually on offer.

Where the same word means something else. Section 18.14.3 applies overvalued and undervalued to an entire country, using the market cap to GDP ratio, with bands from below 50% (undervalued) to above 110% (overvalued). That is a separate test with its own numbers.

CAPM required return = Rf + Beta x (Rm - Rf)

Estimated return < required return  ->  plots BELOW the SML  ->  overvalued
Estimated return > required return  ->  plots ABOVE the SML  ->  undervalued
Estimated return = required return  ->  plots ON the SML     ->  fairly valued

Following the workbook's method with fresh figures. An analyst at a PMS values two stocks. The risk-free rate is 7% and the market risk premium is 8%.

Bharat Steel carries the higher risk and yet offers the lower return relative to that risk. The manager sells it, or does not buy it.

In rupees: a Rs 40,00,000 position in Bharat Steel is expected to return Rs 6,00,000 while an equally risky holding on the SML should return Rs 7,28,000 — a shortfall of Rs 1,28,000 a year for taking on exactly the same market risk. Moving that Rs 40,00,000 into Konkan Chemicals is expected to earn Rs 5,80,000 at roughly half the beta.

The manager's decision does not turn on which stock returns more. It turns on which stock returns more for its risk. That is what plotting against the SML measures, and it is why a high-return stock can still be overvalued.

Chapter 16 (Introduction to Capital Market Theory), section 16.9 (Security Market Line), derives overvalued and undervalued directly from a security's position relative to the SML, with the beta 1.2 / 8% / 14% / 24.8% / 26% example and Exhibit 16.6's securities C and D.

Expect a computation: given a beta, a risk-free rate and a market premium, work out the required return and compare it with a stated estimated return. Then a one-word answer — overvalued, undervalued or fairly valued. The graphical version is equally common: a security plotted below the SML is asked to be identified.

• Below the line means overvalued. The instinct is that low equals cheap, so candidates reverse it. Low return for the risk means a high price.
• The comparison is with the CAPM required return, not with the market return and not with zero. A stock returning 22% can be overvalued if its beta demands 24.8%.
• A high-beta stock is not automatically overvalued. Beta only sets the bar; where the estimated return lands relative to that bar decides the verdict.
• Exhibit 16.6's letters are worth memorising the right way round — C above and undervalued, D below and overvalued.
• An overvalued security under CAPM is not the same as an overvalued market. Section 18.14.3's market cap to GDP bands judge a country, not a stock.
• The label is not the growth or value classification. A high P/E growth stock may plot above the SML and be undervalued; the two tests are unrelated.