The Capital Asset Pricing Model (CAPM) provides a framework for estimating the expected return of an asset, determining the required return based on risk, and identifying overvalued and undervalued assets. These concepts help investors make informed investment decisions.
Expected Return
The expected return of an asset represents the return an investor anticipates based on the CAPM formula:
E(Ri) = Rf + βi(Rm − Rf)
Where:
- E(R_i) = Expected return of asset i
- R_f = Risk-free rate
- β_i = Beta of the asset (systematic risk)
- R_m = Market return
The expected return is influenced by an asset’s systematic risk (beta), as higher-beta assets are expected to yield higher returns to compensate for increased risk. The CAPM assumes that investors are rational and will demand higher compensation for bearing greater risk.
For example, if the risk-free rate is 3%, the market return is 9%, and a stock has a β of 1.2, then:
E(Ri) = 3% + 1.2 (9% − 3%) = 10.2%
This means the investor expects a 10.2% return from the asset based on its risk level.
Required Return
The required return is the minimum return an investor needs to justify investing in an asset, given its risk profile. It is calculated using the CAPM equation and serves as a benchmark for evaluating whether an investment is attractive.
A rational investor will invest only if the expected return meets or exceeds the required return. If an asset’s expected return is lower than the required return, it may not be worth the investment.
For example, if an investor demands a 12% return for a stock but CAPM estimates only a 9% return, the stock does not meet the investor’s risk-return expectations. Conversely, if CAPM suggests a 13% return, the investment is attractive as it exceeds the required return.
The required return helps investors in capital budgeting, portfolio selection, and valuation decisions, ensuring that investments align with their risk tolerance and financial goals.
Overvalued Assets:
An asset is considered overvalued when its expected return (E(R)) is less than the required return (Rr) under CAPM. This indicates that the market price of the asset is higher than its fair value, meaning investors are paying more than the asset’s actual worth.
E(R) < Rr
In this case, investors overestimate the asset’s future performance, or excess demand inflates its price. This often happens due to market speculation, irrational exuberance, or misleading financial reports.
For example, if CAPM suggests a required return of 10%, but the expected return is 7%, the stock is overvalued. Investors might sell it, causing the price to fall toward equilibrium.
Overvalued assets may lead to lower future returns or potential losses if the market corrects itself. Investors following CAPM would typically avoid such assets, opting for better-valued opportunities.
Undervalued Assets
An asset is undervalued when its expected return (E(R)) is greater than the required return (Rr) as per CAPM. This suggests that the asset’s market price is lower than its intrinsic value, providing a potential buying opportunity for investors.
E(R) > Rr
Undervaluation often occurs due to temporary market inefficiencies, investor pessimism, or broader economic downturns. Investors can benefit from these assets as their prices may rise over time, aligning with their true worth.
For example, if CAPM estimates a required return of 9%, but the expected return is 12%, the stock is undervalued. Investors recognizing this opportunity may buy the asset, driving its price up until equilibrium is restored.
Undervalued assets are attractive to value investors like Warren Buffett, who seek opportunities where the market misprices assets. By identifying these assets, investors can generate higher returns while maintaining a disciplined, risk-adjusted approach.