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:

Undervalued stocks- Stocks that are trading below their intrinsic values, are called undervalued stocks. Intrinsic value is the true or real value of a stock that is calculated with the help of Fundamental analysis. Intrinsic value may not be same as current market value of stock so if stock's current market price is lower than the intrinsic value, the stock is considered to be Undervalued and it is good to buy for long term perspective. Long term investors buy undervalued stocks, that perform and grow in the future.

Overvalued stocks- Stocks that are trading above their intrinsic values, are called Overvalued stocks. Stocks whose current market prices are higher than the intrinsic values, are Overvalued. Overvalued stocks may also be good investment after proper analysis. Sometimes overvalued stocks may experience selling pressure.

Systematic risk- It is also called Market risk or overall risk. This risk arises due to economic slowdown, inflation, recession, pandemic etc. This risk affect overall stock market and investors' portfolio also. This is non-diversifiable risk. This can only be minimized by proper Asset allocation.

Risk free rate of return- This is the rate of return, provided by treasury securities or other Government securities, that do not have risk and return is generally fixed but lower.

Market rate of return- It is the average return from the securities available in the market

Risk premium- It is the return expected from the market over the risk free return. It is Market return minus risk free rate of return.

Beta- It is the measure of sensitivity of the security with respect to market. Beta is a measure of systematic risk.