Question 3

Lisa, an equity analyst is considering investment in a stock that a beta of 1.2 and an estimated return of 10 percent. The risk-free return is 3.0 percent and the market return of 12.0 percent. By referring to the Security Market Line (SML), Lisa would conclude that the stock is:

A. undervalued

B. overvalued

C. properly overvalued


Answer is: B

E(R) = 3 + 1.2 * (12 – 3) = 13.8%

The required return of 13.8% is greater than the estimated return of 10%. This results in the stock’s return plotting under the SML. A stock’s return plotted under the SML results in the stock being overvalued because it is offering less than required given its systematic risk.