Question about return rates - overpriced or underpriced?

Question

If the risk-free rate of return is 6 percent and the expected rate of return on the market portfolio is 13 percent, is a security with a beta of 1.25 and an expected rate of return of 16 percent overpriced or underpriced?

Answer 1

That other guy who answered your question is an idiot. Don't listen to him, he needs an education. The formula for your question is .06+(.13-.06)1.25=14.8%. Remember, if a stock has a beta coefficient higher than 1, it is more volatile than the market and, therefore, requires a higher rate of return than the market. As you can see, it does expect a higher return than the 13% the market is expected to offer.

Answer 2

The beta measures volatility (i.e. risk), being 25 % higher than the market. The expected return of the share is the reward for taking this risk, being 23.1 % higher than the market. This suggests that the additional reward is insufficient to cover the additional risk, but not by much, so it would be technically better to invest in the market portfolio (e.g. via a tracker fund).

However, this is somewhat theoretical. The real determinant of whether a share is under or over priced really relates to projected cash flow generation and whether the internal rate of return (discounting cash flow) is sufficient to at least meet your target return. I bought an e-book on Corporate Financial Analysis from www.finysis.net, together with their Financial Analytical Tool, which made calculations of all ratios and cash flow really easy. It also has a discounted cash flow / IRR function enabling easy valuation of shares. Check out the website if you are interested in practical investment skills: www.finysis.net

Answer 3

There is no "risk free" rate of return on a stock. Nobody can accurately forcast what the return will be in the near or far future.

Certain stocks act independent of the general market conditions. Your question is irrevelant.