Wize University Introduction to Finance Textbook > CAPM
Security Market Line (SML)
Popular Courses
COMM 308
Concordia University
Intro to Finance
University Study Guides
Intro to Finance
University Study Guides
FINA 230
Concordia University
MGCR 341
McGill University
FIN 301
University of Alberta
FIN 300
Toronto Metropolitan University
COMM 121
Queen's University
FIN 2000
University of Guelph
FINC 341
Texas A&M University
COMM 2202
Dalhousie University
BU283
Wilfrid Laurier University
FIN 300
Arizona State University - Tempe
BUSFIN 3220
Ohio State University
FINE 2000
York University
FIN 301
Pennsylvania State University
BUS-F 255
Indiana University - Bloomington
FIN 3403
University of Central Florida
FIN 3403
University of Florida
FIN 320
California State University - Fullerton
0:00 / 0:00
The Security Market Line
The security market line (SML) is plotted by setting the expected return as the y-axis and beta as the x-axis. The line starts at the risk-free rate and its slope is determined by the market. The line indicates the required rate of return for every level of risk and is used in determining whether a stock is over-priced, under-priced, or correctly priced.
Market Risk Premium:
How to Interpret:
- Any point above the line represents a stock that is under-priced where the expected return is greater than the required return.
- Any point below the line represents a stock that is over-priced where the expected return is less than the required return.
- Any point on the line represents a stock that is correctly priced where the expected return is equal to the required return.
0:00 / 0:00
Pricing Stocks
The correct (efficient) price of a stock is the present value of future dividends discounted at the required rate of return. When the market price of a stock is below its correct price, the expected return is greater than the required rate of return.
For Example:
If a stock is expected to pay a dividend of $2 per year and the required rate of return is 10%, the correct price for that stock is $20:
If the stock price is currently $19 on the market, the dividend remains $2 so the expected return is greater than the required rate of return:
0:00 / 0:00
Example: The Security Market Line
Stock X has a beta of 1.5, an expected return of 19%, and a standard deviation of 12%. The market risk premium is 7% and the risk-free rate is 3%. Stock X is expected to pay a dividend of $3 next year and increase their dividend by 5% per year thereafter.
- What is the required rate of return on the stock?
- Is the stock overpriced or underpriced?
- What is the correct price of the stock and what is the current market price?
Practice: The Market Line (SML)
The market expected return is 15% with a standard deviation of 11%. The risk-free rate is 4%. Stock X has just paid a dividend of $2.50, which is expected to grow at a rate of 8 percent per year indefinitely.
What is the value of one share of Stock X if it has a beta of 1.7?
0:00 / 0:00
Example: Pricing Stocks Using CAPM
ABC Inc. just paid a dividend of $2 to its shareholders and investors expect the company to increase its dividend by 5% per year. The beta on ABC Inc's stock is 1.99 and the expected return of the market is 12%. If treasury bills are yielding 3.5%, what is the current fair value of the stock using the dividend discount model?
Practice: Pricing Stocks Using CAPM
Stock X is expected to pay a dividend of $3 next year, and 8% more per year indefinitely. The stock has a beta of 2.8 and the market risk premium is 11%. Risk free assets are yielding 2%, what is the fair value of the stock?
Round your final answer to 2 decimal places
| Fair value of Stock X | $ |