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210 Part Two Riskare growth stocks with a low exposure (–.33) to the book-to-market factor. The three-factor
model produces a lower expected return for growth stocks, but it produces a higher figure
for value stocks such as those of banks and construction companies that have a high book-
to-market ratio.
This Fama–French APT model is not widely used in practice to estimate the cost of equity
or the WACC. The model requires three betas and three risk premiums, instead of one beta
and one market risk premium in the CAPM. Also the three APT betas are not as easy to
predict and interpret as the CAPM beta, which is just an exposure to overall market risk.
The Fama–French APT is probably less suited to estimating the cost of equity for an indi-
vidual stock than to providing an alternative way to estimate an industry cost of equity, as in
Table 8.3.
The Fama–French model finds its widest use as a way of measuring the performance of
mutual funds, pension funds and other professionally managed portfolios. If a portfolio man-
ager “beats the S&P,” it may be because he or she has made a bet on small stocks in a period
when small stocks soared—or perhaps he or she had the luck or foresight to avoid growth
stocks in a period when growth stocks collapsed. An analyst can evaluate the manager’s
performance by estimating the portfolio’s bmarket, bsize, and bbook-to-market and then checking
whether the portfolio return is better than the return on a robotically managed portfolio with
the same exposures to the Fama–French factors.Three-Factor Model CAPM
Factor Sensitivities b market b size b (^) book-to-market
Expected
Returna
Expected
Returnb
Autos 1.37 0.62 –0.07 13.4% 12.7%
Banks 1.12 0.02 0.74 13.5 10.6
Chemicals 1.35 0.05 –0.19 10.7 11.3
Computers 1.17 –0.10 –0.33 8.3 9.7
Construction 1.13 0.82 0.57 15.5 12.1
Food 0.52 –0.15 0.00 5.1 5.4
Oil and gas 1.21 –0.20 0.02 9.9 10.1
Pharmaceuticals 0.77 –0.27 –0.31 5.0 4.9
Telecoms 0.87 –0.08 0.04 8.0 8.0
Utilities 0.48 –0.16 0.08 5.2 5.2
❱ TABLE 8.3 Estimates of expected equity returns for selected industries using the Fama–French three-factor
model and the CAPM.
a The expected return equals the risk-free interest rate plus the factor sensitivities multiplied by the factor risk premiums, that is,
rb f + (bmarket × 7) + (bsize × 3.5) + (bbook-to-market × 4.8).
Estimated as rf + β(rm – rf), that is, rf + β × 7. Note that we used simple regression to estimate β in the CAPM formula. This beta may, therefore, be different from
bmarket that we estimated from a multiple regression of stock returns on the three factors.
Source: The industry indexes are value-weighted indexes from Kenneth French’s website, mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.
Used with permission.