Finance question CAPM?

Question

If the expected return on the market is 25% and the risk-free rate is 12%, which of the shares (see page 216) are undervalued?

ri = rf +  (rm – rf)

Share A: ri = 12% + 1.6 (25% – 12%) = 32.8%

Share B: ri = 12% + 0.7 (25% – 12%) = 21.1%

Share C: ri = 12% + 0.5 (25% – 12%) = 18.5%

Share D: ri = 12% + 0.9 (25% – 12%) = 23.7%

Share E: ri = 12% + 1.3 (25% – 12%) = 28.9%

Comparing the expected returns of these five shares, given the CAPM and the information provided, we see that in each case the CAPM return is greater than the return in the question. Given the CAPM, all of the shares are overvalued.

MY QUESTION is how are they overpriced what are we comparing it with?

Answer 1

If the CAPM formula return is greater than the Actual return given by the question in each case, it means that in each case, the actual return i lower because the price of the shares are higher in the market. Therefore, the shares are said to be overvalued. Had the prices been appropriately lower than what they are now in the market, their actual returns would have been higher and equal to the return expected by the CAPM formula. The actual return is the return calculated by IRR method by equating te present value of the expected stream of dividends and the future expected selling price (capital gains) over time to the current market price. If the market price goes up the return falls and vice versa.

Hope this is clear now.

If you buy a share in the market at price X you should be expecting to get the return as per the CAPM formula depending on the risk of the share(volatility in returns). But if the actual return is lower, it means you are buying the share at a price which is higher than its real value in terms of the discounted aggregate value of dividends and capital gins.

Answer 2

this is a tough one.

I don't know