Undervalued stocks plot above the Security Market Line (SML). The SML is a graphical representation of the Capital Asset Pricing Model (CAPM), which is used to determine the expected return of an investment given its level of systematic risk, or beta. The SML plots the expected return of a security against its beta, providing a benchmark for assessing the performance of an investment. Stocks that plot above the SML are considered undervalued because they offer a higher return than what the CAPM would predict given their level of risk. This means that these stocks are providing more return for their level of risk than what is considered fair or average, making them attractive investments. Investors seeking to maximize their returns for a given level of risk would therefore look for stocks that plot above the SML.

Choice B is incorrect. Undervalued stocks do not plot under the SML. If a stock plots below the SML, it indicates that it is overvalued, as its expected return is less than what would be predicted by the CAPM given its level of systematic risk (beta). This suggests that investors are overpaying for the amount of risk they are taking on.

Choice C is incorrect. It's not accurate to say that stocks always plot on the SML. While the SML represents an equilibrium condition where all securities are fairly priced, in reality, due to various market imperfections and investor irrationality, some stocks may be undervalued or overvalued at any given time and thus plot above or below the SML.

Choice D is incorrect. Valuation can indeed be determined using the Security Market Line (SML). The position of a stock relative to this line provides valuable information about whether it might be undervalued or overvalued based on its expected return and systematic risk.

Things to Remember

• Security Market Line (SML) is a graphical representation of the Capital Asset Pricing Model (CAPM).
• SML helps in determining the expected return of an investment based on its systematic risk or beta.
• Stocks that plot above the SML are considered undervalued, offering higher returns for their level of risk.
• If a stock plots below the SML, it is considered overvalued.