A five factors of asset pricing model
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A five factors of asset pricing model
Fust draft. June 2013This draft: September 2014A Five-Factor Asset Pricing ModelEugene F. Fama and Kenneth R. French*AbstractA five-factor model direc A five factors of asset pricing model cted at capturing the size, value, profitability, and investment patterns in average stock returns performs better than the three-factor model of Fama and French (FF 1993). The five-factor model’s main problem is its failure to capture the low average returns on small stocks whose returns behave lik A five factors of asset pricing model e those of firms that invest a lot despite low profitability. The model’s performance is not sensitive to the way its factors are defined. With the adA five factors of asset pricing model
dition of profitability and investment factors, the value factor of the FF three-factor model becomes redundant for describing average returns in the Fust draft. June 2013This draft: September 2014A Five-Factor Asset Pricing ModelEugene F. Fama and Kenneth R. French*AbstractA five-factor model direc A five factors of asset pricing model ch are consultants to. board members of. and shareholders in Dimensional Fund Advisors. Robert Novy-Marx. Tobias Moskowitz, and Eubos Pastor provided helphil comments. John Cochrane. Savina Rizova. and the referee get special thanks.There is much evidence that average stock returns are related to th A five factors of asset pricing model e book-to-market equity ratio. B -\f. There IS also evidence that profitability' and investment add to the description of average returns provided byA five factors of asset pricing model
B/M. We can use the dividend discount model to explain why these variables are 1 elated to average returns. The model says the mar ket value of a sharFust draft. June 2013This draft: September 2014A Five-Factor Asset Pricing ModelEugene F. Fama and Kenneth R. French*AbstractA five-factor model direc A five factors of asset pricing model ) is the expected dividend per share for period r+r. and r is (approximately) the long-term average expected stock return or. more precisely, the internal late of return on expected dividends.Equation (1) says that if at tune t the stocks of two firms have the same expected dividends but different p A five factors of asset pricing model rices, the stock with a lower puce has a higher (long-term average) expected return. If pricing IS rational, the future dividends of the stock With thA five factors of asset pricing model
e lower price must have higher risk. The predictions drawn from (1). here and below, are. however, the same whether the price is rational or irrationaFust draft. June 2013This draft: September 2014A Five-Factor Asset Pricing ModelEugene F. Fama and Kenneth R. French*AbstractA five-factor model direc A five factors of asset pricing model pected investment, and B M. Miller and Modigliani (1961) show that that the tunet total market value of the firm s stock implied by (1) is.^=2E(yr--^,.r)/(l + r)r.-2r-1In this equation Y^.. is total equity' earnings for period f-r and clB.-. = B'-, - Br-^i is the change in total book equity’. Dividi A five factors of asset pricing model ng by time f book equity gives.fE(i;.r-^r)/(l + r/^ = —-----------—------------•-3B;B:Equation (3) makes three statements about expected stock returnsA five factors of asset pricing model
. First, fix everything in (3) except the cunent value of the stock. A/-. and the expected stock return, r Then a lower value of A£. or equivalently aFust draft. June 2013This draft: September 2014A Five-Factor Asset Pricing ModelEugene F. Fama and Kenneth R. French*AbstractA five-factor model direc A five factors of asset pricing model arnings and the expected stock return. The equation then tells us that higher expected earnings imply a higher expected return. Finally, for fixed values of ĨỈỊ. Xft, and expected earnings, higher expected growth in book equity - investment - implies a lower expected return. Staled in perhaps more f A five factors of asset pricing model amiliar terms, (3) says that is a noisy proxy for expected return because the market cap Xi. also responds to forecasts of earnings and investment.TheA five factors of asset pricing model
research challenge posed by (3) has been to identify proxies for expeeled earnings and investments. Novy-Marx (2012) identities a proxy for expected Fust draft. June 2013This draft: September 2014A Five-Factor Asset Pricing ModelEugene F. Fama and Kenneth R. French*AbstractA five-factor model direc A five factors of asset pricing model en investment and average return. (See also Haugen and Baker 1996. Cohen. Gompers. and Vuolteenaho 2002. Fairfield. Whisenant, and Volin 2003. Titman. Wei. and Xie 2004. and Fama and French 2006.2008.) Available evidence also suggests that much of the variation in average returns related to profitab A five factors of asset pricing model ility and investment IS left unexplained by the three-factor model of Fama and French (FF 1993). This leads Us to examine a model that adds profitabilA five factors of asset pricing model
ity and investment factors to the market, size, and B Xi factors of the FF tluee-factoi model.Many “anomaly” variables aie known to cause problems forFust draft. June 2013This draft: September 2014A Five-Factor Asset Pricing ModelEugene F. Fama and Kenneth R. French*AbstractA five-factor model direc A five factors of asset pricing model re the natural choices implied by equations (1) and (3). Campbell and Slnller <1988) emphasize that (1) is a tautology that defines the internal rate of return. r. Given the stock price and estimates of expected dividends, there is a discount rale r that solves equalton (1). With clean surplus accou A five factors of asset pricing model nting, equation (3) follows directly from (I), so it is also a tautology. Most asset pricing research focuses on short-horizon returns - we use a one-A five factors of asset pricing model
mouth horizon in our tests. ĨI’each stock's shor t-horizon expected return is positively related to its internal rale of return in (1) - if. for exampFust draft. June 2013This draft: September 2014A Five-Factor Asset Pricing ModelEugene F. Fama and Kenneth R. French*AbstractA five-factor model direc A five factors of asset pricing model combination of current prices and expectations of future dividends. The decomposition of cashflows in (3) then implies that each stock's relevant expected return is determined by its price-to-book ratio and expectations of its future profitability and investment. If variables not3explicitly linked t A five factors of asset pricing model o this decomposition, such as Size and momentum, help forecast returns, they must do so by implicitly improving foiecasts of profitability and investmA five factors of asset pricing model
ent or by capturing horizon effects in the term structure of expected returns.We test the performance of the five-factor model in two steps. Here we aFust draft. June 2013This draft: September 2014A Five-Factor Asset Pricing ModelEugene F. Fama and Kenneth R. French*AbstractA five-factor model direc A five factors of asset pricing model r versions of the sons that produce the factors. We move to more hostile territoryin Fama and French (FF 2014). where we study whether the five-factor model performs better than the three-factor model when used to explain average returns related to prominent anomalies not targeted by the model. We a A five factors of asset pricing model lso examine whether model failures are related to shared characteristics of problem portfolios identified in many of the sorts examined here - in otheA five factors of asset pricing model
r words, whether the asset pricing problems posed by different anomalies are in part the same phenomenon.We begin (Section I) with a discussion of theFust draft. June 2013This draft: September 2014A Five-Factor Asset Pricing ModelEugene F. Fama and Kenneth R. French*AbstractA five-factor model direc A five factors of asset pricing model ent versions of the factors are in Sections III and IV. Section V presents summary asset pricing tests. One Section V result is that for portfolios formed on size, B A/. profitability', and investment, the five-factor model provides better descriptions of average returns than the FF three-factor mod A five factors of asset pricing model el. Another result is that inferences about the asset pricing models we examine do not seem to be sensitive to the way factors are defined, at least fA five factors of asset pricing model
or the definitions considered here One result in Section V is so striking we caution the reader that it may be specific to this sample: When profitabiFust draft. June 2013This draft: September 2014A Five-Factor Asset Pricing ModelEugene F. Fama and Kenneth R. French*AbstractA five-factor model direc A five factors of asset pricing model ection VI confirms that the large average HAZt return is absorbed by the exposures of HML to the other four factors, especially the profitability and investment factors. Section VII provides asset pricing details, specifically, intercepts and pertinent regression slopes. An interesting Section VII r A five factors of asset pricing model esult is that the portfolios that cause major problems in different sorts seem to be cast in the same mold, specifically, small stocks whose returns bA five factors of asset pricing model
ehave like those of firms that invest a lot despite low4Electronic copy available at https://ssm.com/abstract=2287202profitability. Finally, the papeiFust draft. June 2013This draft: September 2014A Five-Factor Asset Pricing ModelEugene F. Fama and Kenneth R. French*AbstractA five-factor model direc A five factors of asset pricing model ed.1. The five-factor modelGọi ngay
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