Question

Stock L has an expected return of 13.0% with a beta of 1.25, while Stock M has an expected return of 11.5% with a beta of .90. If the risk-free rate is 3.25% and the market risk premium is 8.5%, then are either of these stocks overvalued?

Neither are overvalued

Stock M only

Both are overvalued

Stock L only

Answer 1

As per CAPM,

Required Rate of Return = Rf + Beta x Market Risk Premium

Where Rf = Risk free Rate i.e. 3.25%

Required Rate of Return for Stock L = 3.25% + 1.25 x 8.5% = 13.875%

Required Rate of Return for Stock M = 3.25% + 0.90 x 8.5% = 10.90%

If Required Rate as per CAPM is greater than the expected return the security is overvalued and vice versa

For stock L , Required Rate is 13.875% whereas expected return is 13.0% therefore security is overvalued.

For stock M , Required Rate is 10.90% whereas expected return is 11.5% therefore security is undervalued.

Therefore, correct answer is option 4 i.e. Stock L only

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