Multifactor Models Question

[avanbuiten]

Chapter 21 page 6:

"If the expected return indicated by the multifactor model is lower than that indicated by the share price the share appears cheap"

So say my better model estimates a return of 1% (ie, not very much), but the share price indicates the market estimates the return at 17% (much higher), then the share appears cheap?

Wouldn't it be the case that the market has over-valued the share?

Help please!!!

 

[Meldemon]

If expected return is say $17, then and expected rate of return of 17% indicates a share price of $100.
(solve for price: Expected rate = Expected return / Share price)

An expected rate of 1% (again using an amount of $17) and solving for price would indicate a share price of $1,700. If this is our model, the actual share price appears (VERY) low compared to our 'expected' price.

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Another way of thinking about it - has always been the easier way for me to wrap my grey matter around it:

Total share 'value' = share price now + expected future return

Assume the share value remains constant regardless of price, then a higher expected return would indicate a lower share price & vice versa

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(The core reading tends to take the first approach when discussing this so probably the more 'correct' way to state it in the exam)

Hope this helps!

 

[avanbuiten]

Thanks! Very helpful