Calculating Alpha and Fair Value

Alpha is the difference between the actual return and the expected return, where the expected return is calculated using a risk-adjusted measure like the CAPM. The CAPM formula is used to calculate the expected return of the stock. In the following example, the market return and beta are provided. If the beta of the stock is less than 1, the stock is considered less volatile than the market.

A stock gave a return of 12%. Its beta with the market index is 0.95 and the market return is 10%. Consider risk free rate as 4%. What is the alpha for the stock ? Is the stock fairly valued ? or is it under or over valued? 

Rf = 4%, beta = 0.95, Rm = 10% 

Expected Return = Rf + beta * (Rm – Rf) 

= 4 + 0.95 * (10 – 4) =  4 +  5.7 = 9.7%

Alpha = 12 – 9.7 = 2.3%. The stock is an outperformer. 

No the stock is not fairly valued. It’s under valued.