SML also explains whether a particular stock is overpriced, underpriced or correctly priced. Stocks lying above the SML are undervalued and are expected to earn a higher return corresponding to the risk level. They are considered undervalued because its expected return is higher than the SML based return. Similarly, stocks lying below the SML are overvalued stocks. Stocks plotted on top of the SML are correctly priced.
SML can assist in predicting the expected return of any stock.
SML can help distinguish between an aggressive and a defensive stock. As the Beta of the market is one, it acts as a reference to evaluate the riskiness of the stock. A stock having β>1 is termed as aggressive stock. These stocks are riskier and are expected to earn a higher return.
Similarly, stocks having β<1 are called defensive stocks. These stocks are less risky and hence are expected to earn a lower return.
SML also helps determine whether the stocks are overpriced, underpriced or correctly priced. Stocks that lie above the SML are undervalued stocks. This is because their expected return is greater than the SML based return. Hence these stocks are expected to earn a higher return corresponding to their level of risk. Similarly, stocks that lie below the SML are overpriced stocks. These stocks are considered as overpriced because their expected return is lower than the SML based returns and are expected to earn a lower return corresponding their risk level.