FAMA AND FRENCH MODEL

FAMA and FRENCH model



FAMA and FRENCH model

Introduction

Why were Harry Markowitz and William Sharpe awarded the Nobel prize in economics for their work on asset valuation? The normative or instrumental value of their theories for investors has not, and even can not, be demonstrated. As a positive description of investor behaviour, the theories have been repeatedly falsified, if it is indeed possible to falsify them. The principles for which their theories are valued have been around much longer than the theories themselves. Their quantification of risk has no justification and is not necessarily the best heuristic when an estimate of risk must be made. Their theories even seem to have reached a theoretical dead end, Rather, their theories have been honoured because many, if not most, theoreticians and practitioners have a need for and believe in what they represent—the reduction of the complexities of asset valuation to simple, intuitively expressions suitable for a wide variety of purposes in accounting and finance.

Analysis

Estimation of expected return or cost of equity for individual stocks is central to many financial decisions such as those relating to portfolio management, capital budgeting, and performance evaluation. The two main alternatives available for this purpose are a single-factor model (or Capital Asset Pricing Model [CAPM]) and the three-factor model suggested by Fama and French (1992, for example). Despite a large body of evidence in the academic literature in favour of the Fama and French model, for estimation of portfolio returns, practitioners seem to prefer CAPM for estimating cost of equity (see, for example, [Bruner et al., 1998] and [Graham & Harvey, 2001]). The main objective of this paper is therefore to compare the performance of the Fama French model with that of CAPM for individual stocks.

The view taken in this paper, therefore, is that of a firm estimating its cost of equity. It is assumed that if estimation is based on CAPM, then an estimate for beta is obtained using a simple OLS regression, and this estimate is multiplied by an estimate for the risk premium on the market to obtain an estimate for excess return on equity. If estimation is based on Fama French, then an estimate for the beta for each factor is obtained, also using a simple OLS regression, and these estimates are multiplied by the risk premium for the relevant factor to obtain an estimate for cost of equity. That is, for both CAPM and Fama French, it is assumed that an estimate for cost of equity is obtained using a simple estimation technique, in particular, in relation to the amount of data required for estimation.

Despite the existence of a large academic literature which discusses implementation of CAPM, in particular in relation to estimation of the key parameter beta, there is no consensus in relation to how a best estimate should be obtained. There is no consensus with respect to the index, time frame, and data frequency that should be used for ...