The capital asset pricing model (CAPM) is a measure that describes the relationship between the systematic risk of a security or a portfolio and its expected return. The security market line (SML) uses the CAPM formula to display the expected return of a security or portfolio.
The CAPM formula is the risk-free rate of return added to the beta of the security or portfolio multiplied by the expected market return minus the risk-free rate of return. This yields the expected return of the security. The beta of a security measures the systematic risk and its sensitivity relative to changes in the market. A security with a beta of one has a perfect positive correlation with its market. This indicates that when the market increases or decreases, the security increases or decreases in time with the market. A security with a beta greater than 1 carries more systematic risk and volatility than the market, and a security with a beta less than 1 carries less systematic risk and volatility than the market.
The security market line (SML) is a graphical representation of the CAPM formula. It plots the relationship between the expected return and the beta, or systematic risk, associated with a security. The expected return of securities is plotted on the y-axis and the beta of securities is plotted on the x-axis. The slope of the relationship plotted is known as the market risk premium, the difference between the expected return of the market and the risk-free rate of return, and it represents the risk-return tradeoff of a security or portfolio.
Together, the SML and CAPM formulas are useful in determining if a security being considered for an investment offers a reasonable expected return for the amount of risk taken on. If a security’s expected return versus its beta is plotted above the security market line, it is undervalued given the risk-return tradeoff. Conversely, if a security’s expected return versus its systematic risk is plotted below the SML, it is overvalued because the investor would accept a smaller return for the amount of systematic risk associated.
For example, suppose an analyst plots the SML. The risk-free rate is 1%, and the expected market return is 11%. The beta of stock ABC is 2.2, meaning it carries more volatility and more systematic risk. The expected return of stock ABC is 23%. If the current return of stock ABC is 33%, it is undervalued, because investors expect a higher return given the same amount of systematic risk. Conversely, say the expected return of stock XYZ is 11%, and the current return is 8% and is below the SML. The stock is overvalued: Investors are accepting a lower return for the given amount of risk, which is a bad risk-return tradeoff.