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Information about three stocks is provided below:
| Stock | Expected Return | Beta |
| ABC Corp. | 6% | 0.7 |
| KLM Corp. | 10% | 1.0 |
| XYZ Corp. | 16% | 1.5 |
If the expected market return is 10% and the average risk-free rate is 2%, according to the capital asset pricing model (CAPM) and the security market line (SML), which of the three stocks is most likely undervalued?
Calculate the required return for the three stocks and compare them with
the expected return to see which one is undervalued. For XYZ the required
return = 2 + 1.5 x (10 – 2) = 14. XYZ Corp. is undervalued, because it
lies above the SML. The expected return, 16%, is more than the required
return of 14%.
