The security market line

CAPM has a clean visual form. Plot beta on the horizontal axis and expected return on the vertical, and the CAPM equation becomes a straight line: the security market line (SML).

Reading the line

vertical intercept (beta = 0) -> the risk-free rate
slope                          -> the equity risk premium
any point on the line          -> the fair return for that beta

Every correctly priced asset, according to CAPM, sits exactly on this line. The line says: take on more systematic risk (move right), and you are owed proportionally more return (move up).

Mispricing as distance from the line

The SML turns valuation into geometry:

Above the line -> the asset offers MORE return than its beta warrants
                  = underpriced, attractive (positive alpha)
On the line    -> fairly priced
Below the line -> too little return for its risk
                  = overpriced, unattractive (negative alpha)

Alpha is simply the vertical distance from the security market line. A stock plotting above it is delivering excess return for its risk level.

SML versus the Capital Market Line

These are easy to confuse. The Capital Market Line (from chapter one) uses total volatility on its axis and applies only to efficient portfolios. The security market line uses beta and applies to any asset or portfolio, efficient or not. The SML is the more general statement.

The practical limit

Because the SML is built from beta and an estimated market premium, locating an asset relative to it requires forecasting both — and beta estimates wander depending on the window and the index chosen as "the market". A stock that looks underpriced under one estimate can look fair under another. Use the SML to organize thinking, not as a precise buy signal.