Question

Question # 1. In an investment market, understanding the concept of undervalued and overvalued stocks is very important. Hence, a prudent investor must have good knowledge about Beta, Market Rate of Return and Risk Free Rate of Return.  

Required:

1. Being an investor, critically analyse the conditions of undervalued and overvalued stocks

2. Give a graphical example to present the positioning of:

• Systematic risk

• Risk free rate of return

• Market rate of return, and

• Risk premium.

Answer 1

Answer:-

While investing in the stock market, investors would like to obtain higher returns from the portfolios with minimum level of risk. so as an investor it is necessary to understant about Capital asset pricing model. CAPM explains the relationship between the expected return and risk of an asset. . In CAPM model, it says that unsystematic risk can be reduced through diversification but the systematic risk which is non-diversified, cannot be excluded from the market. The systematic risk can be measured by Beta.

The formula for CAPM is given below:-

Ri = Rf + βi(Rm-Rf)

Where, Ri is the rate of return of a security

             Rf is the risk free rate

             βi is the beta of the investment

             Rm is the return of the market

Security market line is the graphical representation which shows the relationship between the expected return and systematic risk. Security market line can be used to find whether the stock is undervalued or overvalued. The stocks that lie above the security market line ( SML) are considered as overvalued. Because they give higher return at a given amount of risk. The stocks below the SML line are considered as undervalued because they give lesser return at a given amount of risk. The securities on the SML line is considered as fairly valued. The stocks can be valuated using P/E ratio.

Undervalued stocks are the stocks whose market price less than the true value. Overvalued stocks are the stocks whose market price greater than the true value. The stocks with lower P/E ratio is considered to be undervalued and with high P/E ratio is considered to be overvalued.This is because the investors believe that overvalued stocks will give higher returns at a given amount of risk. Also stocks with price/ earnings to growth ratio (PEG) is less than 1 is considered as undervalued and more than 2 is considered as overvalued.

The graphical example to present the positioning of: Systematic risk, Risk free rate of return , Market rate of return, and Risk premium are given below: