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Fama Cross-Section of Expected Stock Returns

Fama Cross-Section of Expected Stock Returns

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American Finance Association
The Cross-Section of Expected Stock ReturnsAuthor(s): Eugene F. Fama and Kenneth R. FrenchSource:
The Journal of Finance,
Vol. 47, No. 2 (Jun., 1992), pp. 427-465Published by: Blackwell Publishing for the American Finance AssociationStable URL:
Accessed: 08/11/2009 16:36
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The Journal of Finance.
The Cross-SectionofExpectedStockReturns
Twoeasilymeasuredvariables,size and book-to-marketequity,combinetocapturethecross-sectionalvariationinaveragestock returns associated with market3,size, leverage, book-to-market equity, and earnings-price ratios. Moreover, whenthetests allow for variationin3that is unrelated tosize,the relation between market/3and average return is flat, even when3is the only explanatory variable.
THEASSET-PRICINGMODELOF Sharpe (1964),Lintner(1965),and Black(1972)
has long shaped the way academics and practitionersthinkabout averagereturns andrisk. Thecentral predictionof themodelisthat the marketportfolioofinvested wealthismean-varianceefficientinthe sense ofMarkowitz (1959).Theefficiency of the market portfolio implies that (a)expectedreturns on securitiesare a positive linearfunctionoftheir marketO3sthe slopeintheregression of a security'sreturn on the market'sreturn),and(b)marketO3suffice to describe the cross-section ofexpectedreturns.There are several empirical contradictions of the Sharpe-Lintner-Black(SLB)model. The mostprominentis the size effect ofBanz(1981).Hefindsthat marketequity,ME(astock'spricetimes sharesoutstanding),adds totheexplanationofthecross-section ofaveragereturnsprovided by marketOs.Averagereturns on small(low ME)stocks are toohigh giventheirfestimates,andaveragereturnson large stocksaretoo low. Another contradiction of the SLB modelis thepositiverelation betweenleverageandaveragereturndocumentedbyBhandari(1988).It isplausiblethat leverageisassociated with risk and expected return,but inthe SLBmodel, leverageriskshould becaptured bymarketS.Bhandarifinds,how-ever,thatleverage helps explainthecross-section of average stockreturnsintests that includesize(ME)as well asA. Stattman (1980) and Rosenberg, Reid, and Lanstein (1985)findthat aver-agereturns onU.S. stocks arepositivelyrelated to the ratio of afirm'sbookvalueofcommonequity, BE,to itsmarket value,ME.Chan, Hamao, andLakonishok(1991)findthat book-to-market equity, BE/ME, also has a strongroleinexplaining the cross-section of average returns on Japanese stocks.
Graduate School ofBusiness, University of Chicago, 1101 East 58th Street, Chicago, IL60637. Weacknowledgethehelpful comments of David Booth, Nai-fu Chen, George Constan-tinides, Wayne Ferson, Edward George, Campbell Harvey, Josef Lakonishok, Rex Sinquefield,Rene Stulz,MarkZmijeweski,andananonymousreferee. This researchissupported bytheNational Science Foundation(Fama) and the Center for ResearchinSecurity Prices (French).
428The Journalof FinanceFinally, Basu(1983) shows that earnings-price ratios(E/P) help explainthe cross-sectionof average returnson U.S. stocks intests that also includesize and market F. Ball (1978)argues that E/P is a catch-all proxyforunnamed factorsin expected returns;E/P is likely to be higher (pricesarelower relative to earnings) for stockswith higher risksand expected returns,whatever theunnamed sources of risk.Ball's proxyargument for E/Pmight also apply tosize (ME), leverage, andbook-to-marketequity. All thesevariables can be regardedas differentwaysto scale stockprices, to extractthe information inprices about riskandexpected returns(Keim (1988)).Moreover, since E/P, ME, leverage,andBE/MEareallscaled versions ofprice, it is reasonableto expect that some ofthem are redundantfor describing average returns.Our goal is to evaluatethejointrolesofmarket A, size, E/P, leverage,and book-to-market equityinthecross-section ofaveragereturns on NYSE, AMEX,and NASDAQ stocks.Black, Jensen,andScholes (1972)and FamaandMacBeth (1973) findthat,aspredicted bytheSLBmodel, thereis apositivesimple relation betweenaveragestock returns and ,3 during the pre-1969period. Like Reinganum(1981) and Lakonishokand Shapiro(1986), we find thatthe relation between
andaveragereturn disappears duringthemore recent1963-1990period,even when
isused alonetoexplain averagereturns.Theappendix showsthatthesimplerelation between
and average returnis also weakin the50-year1941-1990 period.Inshort,our tests do notsupportthemost basicprediction of the SLB model, thataverage stock returnsare positivelyrelatedto market /3s.Unlike thesimplerelation between
andaveragereturn,the univariaterelationsbetweenaveragereturn andsize, leverage,E/P,andbook-to-marketequityarestrong.Inmultivariate tests,thenegativerelation betweensizeandaveragereturnisrobust to theinclusion of other variables.Thepositiverelationbetween book-to-marketequityandaveragereturn alsopersistsincompetitionwithothervariables.Moreover,althoughthe size effecthasattracted more attention,book-to-marketequityhas aconsistentlystrongerroleinaveragereturns.Our bottom-lineresults are: (a) :does not seemtohelp explainthe cross-section ofaverage stock returns, and (b)the combina-tion of sizeandbook-to-marketequityseems toabsorb theroles ofleverageandE/Pinaveragestockreturns,atleastduringour1963-1990sampleperiod.Ifassets are priced rationally,ourresultssuggestthat stockrisks aremultidimensional.Onedimensionofriskisproxiedby size,ME. Anotherdimensionofrisk isproxied byBE/ME,theratio of the bookvalue ofcommonequityto its marketvalue.Itispossiblethat the riskcaptured by BE/MEisthe relativedistressfactor of Chan andChen(1991).They postulatethattheearning prospectsoffirmsare associatedwith arisk factorinreturns.Firmsthat the marketjudges tohave poor prospects, signaledherebylow stockpricesandhighratiosofbook-to-marketequity,havehigher expectedstock returns(theyarepenalizedwithhighercosts ofcapital)thanfirmswithstrong prospects.Itis

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