Overvalued Stock

C

An overvalued stock is a stock that is trading at a price higher than its intrinsic value or fair value. In other words, the market price of the stock does not reflect its true worth. When a stock is overvalued, it means that investors are willing to pay more for the stock than its underlying fundamentals would suggest.

To determine whether a stock is overvalued or not, we need to compare its estimated return with the required return and the expected market return. Let's analyze each answer choice to understand their implications:

A. The estimated return is more than the required return. This answer suggests that the estimated return on the stock is higher than the required return. In financial theory, the required return is the minimum return an investor expects for taking on the risk of investing in a particular stock. If the estimated return is higher than the required return, it implies that the stock is expected to generate a higher return than what investors would typically demand for taking on its associated risk. Therefore, this answer implies an undervalued stock rather than an overvalued one. Hence, option A is incorrect.

B. The return is expected to be less than the expected market return. This answer suggests that the expected return on the stock is lower than the expected market return. The expected market return represents the average return that investors anticipate from the overall market. If a stock's return is expected to be lower than the expected market return, it indicates that the stock is not likely to perform as well as the market as a whole. This situation is consistent with an overvalued stock since investors are willing to pay a premium for a stock that is not expected to outperform the market. Therefore, option B is a plausible explanation for an overvalued stock.

C. The estimated return is less than the required return. This answer suggests that the estimated return on the stock is lower than the required return. As mentioned earlier, the required return is the minimum return expected by investors for the level of risk associated with a stock. If the estimated return is lower than the required return, it indicates that the stock is not expected to generate sufficient returns to compensate for the level of risk involved. However, this situation is more indicative of an undervalued stock rather than an overvalued one. An undervalued stock would present an opportunity for investors to buy at a discounted price relative to its intrinsic value. Therefore, option C is not the correct explanation for an overvalued stock.

D. The return is expected to be greater than the expected market return. This answer suggests that the expected return on the stock is higher than the expected market return. Similar to option A, if the stock's return is expected to be greater than the expected market return, it implies that the stock is expected to outperform the market. This situation typically indicates an undervalued stock rather than an overvalued one because investors are willing to pay a premium for a stock with the potential to generate higher returns than the overall market. Therefore, option D is not a suitable explanation for an overvalued stock.

In conclusion, the correct answer is B. An overvalued stock is one whose return is expected to be less than the expected market return.