Expected Return and Forecasted Return vs. Price expected, conflict, something, different, recommend

grharmeyer

These two Q below are simple on its own but seem to conflict. I get the reasoning of the first Q--your expected return is higher than your forecasted return for the stock, so you recommend a sell. But in the second Q, your expected return is higher, yet you are recommending a buy? Does "price" mean something different than "forecasted return"? I get the feeling that these questions are asking for different things, I'd appreciate some insight. Thanks.





Shankar’s forecasted return for MSS: 11%
Shankar’s forecasted beta for MSS: 1.25
Expected return on the stock market index: 12%
Risk-free rate: 4%
Using his framework of analysis, Shankar should derive the following expected return and buy/sell recommendation for MSS:

Expected Return Recommendation

A) 14% Sell


B) 10% Sell


C) 14% Buy



The correct answer was A) 14% Sell


The equation for the (CAPM) is:

E(R) = RF + a[E(Rm) – RF] = 0.04 + 1.25[0.12 – 0.04] = 0.14 = 14%.
Shankar’s forecasted (11%) is less than the equilibrium expected (or required) return for MSS. Therefore, Shankar should make a sell recommendation on the stock.


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According to the capital asset pricing model (CAPM), if the expected return on an asset is too high given its beta, investors will:

A) sell the stock until the price falls to the point where the expected return is again equal to that predicted by the security market line.

B) buy the stock until the price falls to the point where the expected return is again equal to that predicted by the security market line.

C) buy the stock until the price rises to the point where the expected return is again equal to that predicted by the security market line.


Your answer: A was incorrect. The correct answer was C) buy the stock until the price rises to the point where the expected return is again equal to that predicted by the security market line.

The CAPM is an equilibrium model: its predictions result from market forces acting to return the market to equilibrium. If the expected return on an asset is temporarily too high given its beta according to the SML (which means the market price is too low), investors will buy the stock until the price rises to the point where the expected return is again equal to that predicted by the SML.

bingbingliang

thanks man

tianxin

the show NY Wrote:
-------------------------------------------------------
> theyre 2 different questions actually:
>
> Q1: forecasted return is 11%, but required return
> is 14%. this is not a good investment
> (overvalued) so sell.
>
> Q2: required return should be lets say 15% (this
> is whats used to derive our intrinsic value). but
> in the market its too high (lets say 18%). this
> makes the stock in the market cheaper than what we
> are valuing it at (due to higher r in the
> denominoator). so now the stock is undervalued
> (we valued it higher than its current price), and
> we buy it until the price rises to equilibrium r.
>
> bpdulog: i think this is what you were alluding
> to?

Yup.

NO EXCUSES

bingbingliang

that's right, you can think of it as a bond basically, as price goes up yield goes down (and vice versa).

Pegasus2008

Think in the concrete, not abstract. Here is an example I rigged up:

r = .17
P = 10
g = .1

142.8571

r = .14
P = 10
g = .1

250

Since the required return is higher than what it should be given CAPM expectations, the stock will trade at a lower price; in this case at 143 roughly. The value should be 250, so we should buy.

NO EXCUSES

President1988

2nd question has expectedreturn, higher than required so buy,,they are consistent, just trying to confuse with language in a round about way.

yalo

expected return=return from DDM or some such model.
required return=CAPM return.

What is return used for? Discounting to arrive at PV(Cash Flows)=Price.

If Return increases -> PV Decreases - so Price reduces. (It gets underpriced).

Case 1:
Shankar’s forecasted return for MSS: 11% <-- Expected Return
Shankar’s forecasted beta for MSS: 1.25
Expected return on the stock market index: 12%
Risk-free rate: 4%

From CAPM -> Required Return=14% <-- Required Return.

If you valued Cash flows at the Expected Return of 11% -> your Price will be HIGHER -- the security will be OVERPRICED --> so SELL.

Case 2: According to the capital asset pricing model (CAPM), if the expected return on an asset is too high given its beta, investors will:

Expected Return is too HIGH. So PRICE will be TOO LOW.. SO BUY.
When you BUY - Price would increase (due to demand for the asset). When Price increases -- Return would reduce....

CP

Analyze_This

In Q2, it says "if the expected return on an asset is too high given its beta", emphasis on "given its beta", as "given its beta" you can calculate CAPM required return. So the sentence means that the expected return is higher than the CAPM required return, thus the asset is undervalued and you should buy it.