How do I interpret a Security Market Line (SML) graph?

The Capital Asset Pricing Model, or CAPM, shows the relationship between an asset's expected return and beta. The foundational assumption of the CAPM is that securities should offer a risk-adjusted market premium. The two-dimensional correlation between expected return and beta can be calculated through the CAPM formula and expressed graphically through a security market line, or SML. Any security plotted above the SML is interpreted as undervalued. A security below the line is overvalued.

Fundamental analysts use the CAPM as a way to spot risk premiums, examine corporate financing decisions, spot undervalued investment opportunities and compare companies across different sectors. The SML graph can also be used to study investor behavior by market economists. Perhaps most importantly, the SML can be used to determine whether assets should be added to a market portfolio. The goal is to maximize expected return relative to market risk.

There is another important graphical relationship associated with the CAPM: the capital market line, or CML. It is easy to get the CML confused with the SML, but the CML only deals with portfolio risk. The SML deals with systematic, or market, risk. Traditionally, a portfolio risk can be diversified away with the right security selections. This is not true with SML, or systematic risk.

A standard graph shows beta values across its x-axis and expected return across its y-axis. The risk-free rate, or beta of zero, is located at the y-intercept. The purpose of the graph is to identify the action, or slope, of the market risk premium. In financial terms, this line is a visual representation of the risk-return tradeoff.

After running different securities through the CAPM equation, a line can be drawn on the SML graph to show a theoretical risk-adjusted price equilibrium. Any point on the line itself shows the appropriate price, sometimes called the fair price.

It is rare that any market is in equilibrium, so there may be cases where a security experiences excess demand and its price increases belong where CAPM indicates the security should be. This reduces expected return. Any gap between the actual return and the expected return is known as alpha. When alpha is negative, excess supply raises expected return.

When alpha is positive, investors realize above normal returns. The opposite is true with negative alphas. According to most SML analysis, consistently high alphas are the result of superior stock-picking and portfolio management. Additionally, a beta higher than 1 suggests the security's return is greater than the market as a whole.

Several different exogenous variables can impact the slope of the security market line. For example, the real interest rate in the economy might change; inflation may pick up or slow down; or a recession can occur and investors become generally more risk-averse.

Some shifts leave the market risk premium itself unchanged. For example, the risk-free rate may move from 3 to 6%. The risk premium on a given stock might shift accordingly from 5.5 to 8.5%; in either scenario, the risk premium is 3%.