• The ______ asserts that when stock prices are at equilibrium level, the rate of return that investors can expect to earn on a security is r_f + β [E (r_M) – r_f].
• Thus, _____ may be viewed as providing the rate of return an investor can expect to earn on a security given its risk as measured by Beta.
• This is the return that investor will require of any other investment with equivalent risk.
• The required rate of return is denoted by k.
• If a stock is priced correctly then a “fair” return to the investor is expected that means the expected return will equal its required return.

But, somehow the goal of a security analyst is to find stocks that mispriced like an underpriced stock will provide an expected return greater than the required return.

capital asset pricing model (CAPM)

• Another way to see this is to compare the intrinsic value of a share of stock to its market price.
• The intrinsic value, denoted V₀, of a share of stock is the present value of all cash payments to the investor in the stock, including dividends and proceeds from the ultimate sale of the stock, discounted at the appropriate risk-adjusted interest rate, k.

• Whenever the intrinsic value, or the investor’s own estimate of what the stock is really worth, exceeds the market price, the stock is considered undervalued and a good investment.
• In the case of CZG, using a one-year investment horizon and a forecast that the stock can be sold at the end of the year at price P₁ = 52 pesos, the intrinsic value is

V₀ = E(D₁) + E (P₁) / 1 + k = 4 + 52 / 1.12 = 50

• Equivalently, at a price of 50, the investor would derive a 12% rate of return just equal to the required rate of return on an investment in the stock.
• However, at the current price of 48 pesos, the stock is underpriced compared to intrinsic value.
• At this price, it provides better than a fair rate of return relative to its risk.
• Using the terminology of CAPM, it is a positive-alpha stock, and investors will want to buy more of it.

• In contrast, if the intrinsic value turns out to be lower than the current market price, investor should buy less of it.

• In market equilibrium, the current market price will reflect the intrinsic value estimates of all market participants.
• This means the individual investor whose V₀ estimate differs from the market price, P₀, in effect must disagree with some or all of the market consensus estimates of E(D₁), E(P₁), or k.
• A common term for the market consensus value of the required rate of return, k, is the market capitalization rate.