What prices are compared to decide a security is over-valued, fairly valued or under-valued?

Question

The Capital Asset Pricing Model (CAPM) for asset i is

E(R_i) = R_f + \beta_{i} (E(R_m) - R_f)

It can be used for asset pricing

We can compare the expected/required rate of return, E(R_i), calculated using CAPM, to the asset's estimated rate of return, based on either fundamental or technical analysis techniques (including P/E, M/B etc), over a specific investment horizon to determine whether it would be an appropriate investment.

Assuming that the CAPM is correct, an asset is correctly priced when its estimated price is the same as the present value of future cash flows of the asset, discounted at the rate suggested by CAPM. If the observed price is higher than the CAPM valuation, then the asset is undervalued (and overvalued when the estimated price is below the CAPM valuation)

Questions:

1. I was wondering how "future cash flows of the asset" are predicted? Are they also predicted using fundamental and/or technical analysis?
2. It seems like calculating expected/required rate using CAPM does not belong to either fundamental or technical analysis, does it? If indeed not belong, how are fundamental and technical analysis different from CAPM? I just would like to have some big picture.

3. In the quote, two kinds of prices have been mentioned:

   • the present value of future cash flows of the asset, discounted at some rate such as the rate suggested by CAPM, (called intrinsic price/value, if I am correct?)

   • the asset's estimated price as well as estimated rate of return, based on either fundamental or technical analysis

   In the context of security valuation, I remember I also saw there are two other kinds of prices

   • the book price/value

   • the current real price on the markets

   I wonder when deciding whether an asset is over/fair/under-valued, ususally what kind of price is compared to what other kind of price?

   Why is it in the quote to compare the first two kinds of prices, instead of comparing the current real price on the markets to any of the other three kinds?

Thanks and regards!

Answer 1

I was wondering how "future cash flows of the asset" are predicted? Are they also predicted using fundamental and/or technical analysis?

There are a many ways to forecast the future cash flows of assets. For example, for companies:

• The most corporate people (and maybe the most fundamental) would take a deep look at the company and the economy (accounting, business plan, shareholders, past earnings, inflation, etc...) and try to make a forecast for a few years, and then extrapolate that for a "very long period", often by assuming a constant growth rate of earnings.
• Statistical models and economic variables to try to predicts future cash flows (ex: with this unemployment, this inflation and this interest rate, statistics shows that the future cash flows should be that much).
• By comparison. If you have forecasts for certain assets, you can try to extrapolate it to other assets. But they need to have some common points (sector, geographical exposure, etc..)
• Others: like using charts pattern (which is basically statistics on price patterns), etc...

It seems like calculating expected/required rate using CAPM does not belong to either fundamental or technical analysis, does it?

I would qualify the CAPM as quantitative analysis because it's mathematics and statistics. It's not really fundamental since its does not relies on economical data (except the prices). And as for technical analysis, the term is often used as a synonym for graphical analysis or chartism, but quantitative analysis can also be referred as technical analysis.

the present value of future cash flows [...] (called intrinsic price/value, if I am correct?)

Yes you are correct.

I wonder when deciding whether an asset is over/fair/under-valued, ususally what kind of price is compared to what other kind of price?

If it's only to compare with the price, usually, the Net asset value (which is the book value), the Discount Cash flows (the intrinsic value) and the price of comparable companies and the CAPM are used in comparison to current market price of the asset that you are studying.

Why is it in the quote to compare the first two kinds of prices, instead of comparing the current real price on the markets to any of the other three kinds?

Actually the last line of the quote says that the comparison is done on the observed price which is the market price (the other prices can't really be observed).

But, think that the part:

an asset is correctly priced when its estimated price is the same as the present value of future cash flows of the asset

means that, since the CAPM gives you an expected rate of return, by using this rate to compute the present value of future cash flows of the asset, you should have the same predicted price.

I wrote this post explaining some valuation strategies. Maybe you can find some more information by reading it.