While making an investment decision, understanding the concept of the return is pertinent. A basic question one should analyze is that – how much do you expect to earn from investing in the stock? What is the minimum required rate of return that you should expect the stock to deliver, given its attributes? All such critical questions are approximately answered by various financial models. The use of such models is more of an art than science. One basic model that is popular among investors is the capital asset pricing model (CAPM).
CAPM is the single factor model where equity risk premium is the only factor used. The formula for CAPM is: Expected returns = Risk-free rate + beta*equity risk premium. The model is easy to understand but empirical evidence has suggested that the CAPM beta does not fully capture the business risk.
In 1993, two researchers Eugene Fama and Kenneth French came up with a model to overcome the limitations of the CAPM. They observed that the investments made in smallcap stocks with the value style had generated higher returns over a long period. And hence, they incorporated these two factors into the CAPM, which came to be known as ‘Fama & French’ model. Eugene Fama later received Nobel Prize in Economic Sciences.
The Fama-French model looks like this:
Expected returns= RFR + Beta(market)*RMRF + Beta(size)*SMB + Beta(value)*HML where,
RMRF= Equity risk premium
SMB= Small minus big (a size factor)
HML= High minus low (growth vs value stock)
Beta is the factor sensitivity.
Let us try to understand the broader picture and how can it be useful to understand the concept of the return. The model states that the expected returns for a stock is driven by its sensitivity to market returns, sensitivity to size and sensitivity to value stocks, as measured by the book-to-market ratio.
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