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Journal of

APPLIED CORPORATE FINANCE
A MO RG A N S TA N L E Y P U B L I C AT I O N

In This Issue: Risk and Valuation
Downsides and DCF: Valuing Biased Cash Flow Forecasts CARE/CEASA Roundtable on Managing Uncertainty and Risk
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Richard S. Ruback, Harvard Business School Panelists: Steve Galbraith, Maverick Capital; and Neal Shear. Moderated by Trevor Harris, Columbia University

How the U.S. Army Analyzes and Copes with Uncertainty and Risk Accounting for Sovereign Risk When Investing in Emerging Markets

34 41

Major Hugh Jones, U.S. Military Academy V. Ravi Anshuman, Indian Institute of Management Bangalore, John Martin, Baylor University, and Sheridan Titman, University of Texas at Austin

Accounting for Risk and Return in Equity Valuation Morgan Stanley’s Risk-Reward Views: Unlocking the Full Potential of Fundamental Analysis How Corporate Diversity and Size Influence Spinoffs and Other Breakups

50 59

Stephen Penman, Columbia Business School Guy Weyns, Juan-Luis Perez, Barry Hurewitz, and Vlad Jenkins, Morgan Stanley

69

Gregory V. Milano, Steven C. Treadwell, and Frank Hopson, Fortuna Advisors LLC

The Three-Factor Model: A Practitioner’s Guide Valuing Companies with Cash Flow@Risk

77 85

Javier Estrada, IESE Business School Franck Bancel, ESCP Europe, and Jacques Tierny, CFO, Gemalto

Valuing an Early-Stage Biotechnology Investment as a Rainbow Option Terminal Value, Accounting Numbers, and Inflation

94 104

Peter A. Brous, Seattle University Gunther Friedl, Technische Universität München, and Bernhard Schwetzler, HHL Leipzig Graduate School of Management

Comment on “Terminal Value, Accounting Numbers, and Inflation” by Gunther Friedl and Bernhard Schwetzler

113

Michael H. Bradley, Duke University, and Gregg A. Jarrell, University of Rochester

For example.” Journal of Financial Economics. Kenneth Eades. FT Prentice Hall. I would like to thank Mark Kritzman and Jack Rader for their comments. whenever these two returns are different. whereas beta is specific to the asset considered. and also as an input in the calculation of excess returns. R i = R f + RPi . and the risk premium is the compensation for bearing the risk of an asset. And it specifies that the compensation for risk should be measured by the risk premium required for investing in uity. the risk premium of asset i can be estimated as follows: RPi = MRP∙βi (2) where MRP represents the market risk premium and βi is the beta of asset i. In both cases. Robert Harris. As noted earlier. (3) A Brief Review of the CAPM The required return on any asset i (R i ) can be estimated as the sum of two variables: the risk free rate (R f ) and the asset’s risk premium (RPi ). see Robert Bruner. 1. This is the case because. Beta is a measure of the sensitivity of the asset’s returns to fluctuations in the market’s returns. and John Graham and Campbell Harvey (2001). That required return can be used as an input in the calculation of the cost of capital. T premium should be estimated as the product of the market risk premium and the asset’s beta. then. it discusses the model’s foundations. only one has slowly but steadily emerged to become a strong contender—namely. this model suggests that an asset’s risk * This article draws heavily from Chapter 8 of my book The FT Guide to Understanding Finance. Journal of Applied Corporate Finance • Volume 23 Number 2 A Morgan Stanley Publication • Spring 2011 77 . selling pressure is expected to push the asset’s price down and its expected return up. 13-28. IESE Business School* here is no doubt that the Capital Asset Pricing Model (CAPM) is one of the models most widely used in finance. in the equilibrium assumed by this model. if investors expect this asset to yield only 5%. Gabriela Giannattasio provided valuable research assistance. This risk premium is precisely what the CAPM provides a way to estimate. Spring/Summer. “The Theory and Practice of Corporate Finance: Evidence from the Field. if investors require a 10% annual return from an asset but expect it to yield 15%. the CAPM is far from uncontroversial. Conversely. and is also apparent from expression (2). “Best Practices in Estimating the Cost of Capital: Survey and Synthesis. 187-243. The CAPM suggests that investors should require compensation for the expected loss of purchasing power and for bearing risk. and thereby provide a more reliable estimation of an asset’s required return. This article aims to provide practitioners with a practical introduction to the 3FM by discussing an alternative to the CAPM for estimating required or expected returns. buying pressure is expected to drive the asset’s price up and its expected return down.” Financial Practice and Education. and Robert Higgins (1998).The Three-Factor Model: A Practitioner’s Guide by Javier Estrada. In fact. That being said. Over 70-80% of practitioners claim to use this model to estimate the cost of eq- which is the usual way to express the CAPM. whereas the risk premium is specific to the asset considered. the market risk premium is the same for all assets. a measure at the center of performance evaluation and portfolio management. Combining equations (1) and (2) we get the following: R i = R f + MRP∙βi . 2011. The views expressed below and any errors that may remain are entirely my own. the three-factor model (3FM). As expression (1) shows. Note that this expression yields both the required return and the expected return for a given asset.1 But despite its widespread use. 60. of the many models that have challenged the supremacy of the CAPM over the years. (1) The risk-free rate is the compensation required for the expected loss of purchasing power. an important variable in most corporate investment decisions. intuition. the risk-free rate is the same for all assets. The intuition behind expression (3) is straightforward. Debate on its merits has been raging on for decades. This model aims to assess risk more comprehensively than the CAPM. the adjustment is expected to continue until the required and the expected return are the same. assets with a beta higher (lower) than 1 magnify (mitigate) the market’s fluctuations. and a consensus on its usefulness is nowhere in sight. Expressed as an equation. prices are assumed to adjust to restore the equality. The market risk premium is the compensation required by investors for investing in relatively risky stocks as opposed to (ultimately risk-free) government bonds. To that end. and applications to both corporate finance and portfolio management. According to the CAPM.

a supporter of the CAPM would justify it in at least two ways. One of the earliest analysis of the relationship between size and stock returns is in Rolf Banz (1981). companies with high BtM tend to deliver higher returns than those with low BtM. however strong this statement may be. The evidence on this seems to point to the fact that small companies and value companies are less profitable (they have lower earnings or cash flow relative to book value) than large companies and growth companies. one of the earliest formal analysis of the relationship between cheapness and stock returns is in Sanjoy Basu (1983). You can pick your side on this debate. But those are just stories. that cheap (value) stocks outperform expensive (growth) stocks. 12. In short. investors are expecting a rebound but may get a falling knife. the theoretical reasons for the existence of these premiums are much less convincing. that is. Some may not consider this a problem. as long as we can isolate the variables that explain differences in returns.” Journal of Financial Economics. The simplicity of this model. 9. Although value investing has a very long history.relatively risky stocks instead of less risky bonds. The problem is that there is a huge amount of evidence on both sides of the fence. Market Value. One last issue before we discuss this model. unlike the vast majority of its contenders. the CAPM is solidly grounded in theory. and with different methodologies. there is a heated controversy about Relationship Between Earnings Yield. the evidence alone does not enable to either embrace or reject the CAPM. In other words. it would claim that. 3-18. As a result. as the recent financial crisis reminded us. the evidence quite clearly shows that small stocks outperform large stocks. no model of optimal behavior leads to a result in which stock returns depend on market cap and BtM. the CAPM’s strong statement is not an assumption but the result of a model of optimal behavior. Yet others would argue that there is no point using models that do not follow from a sound underlying theory. Liquidity. “The cheap and expensive stocks relative to book value. “Parallels Between the Cross-Sectional Predictability of Stock and Country Returns. a size premium. cheap (also known as “value”) stocks tend to outperform expensive (also called “growth”) stocks.4 To summarize. and therefore why they should deliver higher returns. See Cliff Asness. these two risk premiums seem to make sense. In fact. and Ross Stevens (1997).3 But if the evidence on the size and value premiums is rather clear. The second argument would be empirical. and are therefore perceived by investors as riskier. 78 Journal of Applied Corporate Finance • Volume 23 Number 2 A Morgan Stanley Publication • Spring 2011 . This empirical regularity is usually known as the value premium. Recall that beta is a measure of systematic risk. Putting all this together. is a good example of a risk that seemed to pervade the entire financial system. beta must be the only relevant risk factor.” Journal of Portfolio Management. liquidity risk. Recall that this ratio is a measure of cheapness in the sense that high and low BtM indicate 2. “The Relationship Between Return and Market Value of Common Stocks. and that small and value companies are less profitable than large and growth companies. The first argument would be theoretical. And the evidence shows that. then. 3. Small companies are likely to be less diversified and less able to survive negative shocks than large companies. though. it would claim that a vast amount of research supports the plausibility of the CAPM. it would argue that in a world in which investors behave optimally. In addition. it is not hard to come up with plausible stories to explain why small and cheap stocks are riskier than large and expensive stocks. 129-156. over different time periods. however. and Return for NYSE Common Stocks: Further Evidence. The Size and Value Premiums And yet at least some empirical evidence is surprisingly consistent. and as many others sources of firm-specific or “idiosyncratic” risk as you can imagine are all irrelevant when assessing the required return of an asset (though some of these factors may be reflected in beta and therefore have a systematic component). That implies that bankruptcy risk. small companies tend to deliver higher returns than large companies. we conclude that stock returns are determined by a market premium. over the long run. data for different countries and over different time periods show a consistent positive relationship between book-to-market ratios (BtM) and returns. And yet. currency risk. As for cheap companies. we should use them to determine required or expected returns. Although the evidence on the existence of the size and value premiums is largely undisputed. 79-87. conceals a very strong statement. small companies and value companies may be distressed because of their poor profitability. Spring. A better alternative may be to establish empirical links from size and value to credible sources of risk. There is a massive amount of research testing the validity of the CAPM in different countries. adjusted by a factor specific to each asset that reflects how much more or less risky the asset is relative to the market. over the long term. Those who support the CAPM and those who dismiss it can point to a vast amount of evidence that supports their position. If you think a bit about it.” Journal of Financial Economics. Data for different countries and over different time periods show a consistent negative relationship between market capitalization and returns. they would claim that. In other words. This empirical regularity is usually known as the size premium. 4. and a value premium—and that is the main insight of the 3FM. John Liew. But this is a tricky argument. well. the CAPM suggests that stocks with high systematic (or market) risk should outperform those with low systematic risk.2 Similarly. there must be a reason why they are cheap! When buying value stocks. in the long term. In other words.

What is an appropriate portfolio of small stocks—and of large stocks? What is an appropriate portfolio of value stocks—and of growth stocks? Should we estimate betas using daily. that is. Implementation of the 3FM Like the CAPM. Recall also that it is measured by the average historical difference between the return of a widely diversified portfolio of stocks and the return of government bonds.” Journal of Finance. we will focus here on the essentials and leave interested readers to explore further details on their own. but it’s important to keep in mind that estimating required returns with the 3FM amounts to an implicit acceptance of the second point of view. and βiS and βiV denote the return sensitivity of asset i to changes in these premiums. neither SMB nor HML in expression (4) have a subscript i. Again you can pick your side on this debate.edu/pages/faculty/ken. measures the sensitivity of asset i’s risk premium to fluctuations in the size premium. which is exactly what one would expect in an efficient market. its size (measured by market cap). which is why you may occasionally find this model referred to as the Fama-French 3FM. See http://mba. Their seminal article on the subject is Eugene Fama and Kenneth French (1992). this model states that the higher an asset’s exposure to the size and value premiums—in other words. The 3FM was proposed by Eugene Fama and Kenneth French in a series of articles published in the 1990s. A widely accepted (though by no means only) choice is the yield on 10-year Treasury notes. which has become the benchmark rate for all other maturities.whether or not the excess returns of small and value stocks (relative to large and growth stocks) are the result of their higher risk. measures the sensitivity of asset i’s risk premium to fluctuations in the value premium. The value premium is measured by the average historical difference between the returns of a portfolio of high-BtM stocks and those of a portfolio of low-BtM stocks. the size premium (SMB) seeks to capture the additional compensation required by investors for investing in relatively riskier small companies as opposed to 5. where SMB (small minus big. This is the case because. usually called the value beta (βiV ). that is. According to the 3FM. the value premium (HML) seeks to capture the additional compensation required by investors for investing in relatively riskier value stocks as opposed to relatively safer growth stocks. Other than that. note that the size beta and the value beta (as well as the market beta) do have a subscript i. referring to market cap) and HML (high minus low. Recall that the market risk premium (MRP) seeks to capture the additional compensation required by investors for investing in relatively riskier stocks as opposed to relatively safer bonds. Yet others argue exactly the opposite. and therefore are specific to the asset considered. but we will use here the 10-year yield. and theory has little to say about this. the higher the asset’s risk as defined by the 3FM—the higher should be the asset’s required return. as we will discuss shortly. Journal of Applied Corporate Finance • Volume 23 Number 2 A Morgan Stanley Publication • Spring 2011 79 . monthly. finally. In similar fashion. or annual data? And how long a period should we use to estimate those betas? And to estimate the risk premiums? Theory offers no clear guidance and there are only more and less widely accepted answers to these questions. usually called the size beta (βiS ).html. for which we need some additional data. “The Cross-Section of Expected Stock Returns. the required return on any asset i follows from the expression R i = R f + MRP∙βi + SMB∙βiS + HML∙βiV . A quick comment before we get to specifics. For that reason. and its valuation (measured by BtM). And the beta associated with this factor.5 In the “Data Library” that appears on Ken French’s web page.tuck. referring to BtM) denote the size premium and the value premiums. An Overview of the 3FM Estimating required returns with the 3FM is just a bit more difficult than with the CAPM because we need to estimate two more risk premiums and two more betas.dartmouth. just as we stressed earlier about the MRP. 427-465. (4) relatively safer large companies.french/data_library. Let’s think a bit about this expression. 47. And the beta associated with this factor. the model poses no real challenge for any practitioner that wants to implement it. the required return on an asset follows from its exposure to the market. as well as the data necessary to implement it (in the “Historical Benchmark Returns” section of the page).6 you will find plenty of information on this model. Some people might make plausible arguments for using yields of shorter or longer maturity. that βi measures the sensitivity of asset i’s risk premium (RPi = R i –R f ) to fluctuations in the market risk premium. And recall. Note that. More precisely. Finally. small and value stocks are not riskier than large and growth stocks. Let’s start with the risk-free rate. and therefore the additional returns they provide are a free lunch courtesy of an inefficient market. Conversely. Some argue that this is not the case. 6. weekly. This means that the size and value premiums (as well as the risk-free rate and the market risk premium) are the same for all assets. the 3FM is silent about several practical issues that are inevitably faced when implementing this model. small and value stocks offer higher returns than large and growth stocks precisely because they are riskier. The size premium is measured by the average historical difference between the returns of a portfolio of small stocks and those of a portfolio of large stocks.

3 AM (1927-2009) GM (1927-2009) French’s web page provides annual figures for MRP. 2. (5) 7.1 6.1 5. and value stocks outperformed growth stocks by 3. All data taken from Ken French’s web page.9 30.0 –0. And the HML is estimated as an average of the annual differences between the return of a portfolio of high-BtM stocks and that of a portfolio of low-BtM stocks.9 HML 21.1 6.4 29. (6) Note that this expression is the same as (4) but with specific values for R f .3%. MRP. 8.1 13. stocks outperformed bonds by 5.1 23. where α .0 –7. In both cases.033⋅βiV . small stocks outperformed large stocks by 2. and β3 are coefficients to be estimated. This is one of the many tricky issues that practitioners face when implementing both the CAPM and the 3FM.3 26.4 8.8 29.0 16.8 7. the size premium (SMB). and for the sake of comparison. we will assume that we are at the very beginning of 2010. let’s also estimate the cost of equity of the same companies with the CAPM. Given these figures. Using five years of monthly data is a widely accepted (though by no means the only) alternative. and HML portfolios for this purpose are also available from French’s web page. SMB. and value beta of the 30 companies in the Dow. that is.3 –2. Similarly.2 SMB –14. expression (4) states that we need three betas.9% a year.1 –3. 5. Importantly. For the risk-free rate we will use the yield on the 10-year Treasury note. and HML we will use the geometric averages for 1927-2009 on the last line of Table 1.7 HM –10. Rit – Rft = α + β1∙MRPt + β2∙SMBt + β3∙HMLt + ut .9 –21. which at the beginning of 2010 was 3.7 3.2 11.8 Monthly returns for the MRP. SMB. Application 1 – Estimating the Cost of Equity Let’s now put everything together and use the 3FM to estimate the cost of equity for the 30 companies in the Dow.4 4.2 10. it is enough to highlight that the MRP in expression (4) is estimated as an average of the annual differences between the return of a diversified portfolio of stocks and the return of government bonds.4 –4. For our practical purposes.7 28.4 28. and HML. and t indexes time.4 20.1 19. β2. monthly) and how far back we need to go when estimating these betas. Based on the geometric averages in the last line of the table.7 3. SMB. For MRP.039 + 0. weekly.7 11. that is. and value premiums (MRP.1 8. size beta.9 –3.5 0. we will then estimate the cost of equity on the 30 stocks in the Dow at the beginning of 2010 with the expression R i = 0. this regression is often estimated with monthly data over a five-year period.9%.7 4.9 SMB –5. SMB.9 –1.029⋅βiS + 0.1 –15. As is the case with the CAPM.7 –23.1 17.0 0.8 –38. Finally.6 –9.059⋅βi + 0.4 3.Table 1 Risk Premiums  This exhibit shows the market risk premium (MRP).8 2. The theory is also silent about whether we should use an arithmetic or a geometric average. 80 Journal of Applied Corporate Finance • Volume 23 Number 2 A Morgan Stanley Publication • Spring 2011 . the SMB is estimated as an average of the annual differences between the return of a portfolio of small stocks and that of a portfolio of large stocks.2 3. β1. SMB. Again theory is of little help in determining the frequency of the data (daily.9%.8 –22. and HML over the period 1990-2009. u is an error term.9% a year.5 7. β2 is the size beta (βiS). as well as a detailed explanation on how these magnitudes are estimated.4 27.2 3.9%.4 –6. and β3 is the value beta (βiV ).7 Table 1 shows the values of MRP. SMB. Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 MRP –13.7 –14. All we need now to estimate required returns with the 3FM are the beta. and HML from 1927 on.3% a year. size.7 10. All figures are annual and expressed in %.0 –39. and 3. so we will not get into any details here.7 15.1 31. as well as the arithmetic and geometric averages over the much longer period 1927-2009.7 1.6 –15.6 0.1 23. It also shows the arithmetic (AM) and geometric (GM) average for the three risk premiums over the 1927-2009 period.4 Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 MRP –16. these three betas must be estimated jointly by running a time-series regression between the risk premium of stock i (RPi = Ri –Rf ) and the three portfolios that capture the market.5 0. and the value premium (HML) between 1990 and 2009. Note that β1 is the usual (market) beta.4 16.3 11. and HML).2 17.

2% –0.11 0.23 –1.41 1.41 0. the CAPM.32 –0.58 2.71 0.49 1.15 0.7% 0.45 0.1% 17.7% 0.5% 7.51 –0.67 –0.1% 9.10 2.11 1.5% 11.2% –0.18 –0.2% 12.04 0.88 0.3% 12.4% –1.60 0.55 –0.38 1.0% –0.20 0.23 2.1% 0.09 0.22 0.1% 5.2% 0.36 1.6% 1.25 –0.5% βi 0.8% –1. and the Cost of Equity  This exhibit shows.36 –0. across all 30 companies.4% 8.79 –0.3% 17.21 1. and HML portfolios downloaded from Ken French’s web page.89 0.8% 4.26 1.9% 8.38 0.26 0.3% 14.04 –0.09 1.5% 0.09 0.4% 7.0% 0.8% 6.12 0.6% 10.46 0.2% 12.76 2.1% 10.4% –0.2% 6.1% –1.5% 11.08 0.2% 7.5% –0. It also shows the market beta estimated from expression (5) in the sixth column. the market beta (β i).3% 10.72 0. in both cases omitting the size and value factors.5% 0.05 0.87 0.44 0.71 1.67 0.3% –0.66 2.20 0.62 1.3% 16.99 CAPM 8.4% –0.56 0.2% Journal of Applied Corporate Finance • Volume 23 Number 2 A Morgan Stanley Publication • Spring 2011 81 .56 1.6% 6. Company 3M Alcoa American Express AT&T Bank of America Boeing Caterpillar Chevron Cisco Systems Coca-Cola DuPont Exxon Mobil General Electric Hewlett-Packard Home Depot Intel IBM Johnson & Johnson JPMorgan Chase Kraft Foods McDonald’s Merck Microsoft Pfizer Procter & Gamble Travelers United Technologies Verizon Communications Wal-Mart Walt Disney Min Max Avg βi 0.4% 6.89 –0. size beta (β iS).4% 9.5% 11.52 1.30 1.9% 7.94 0.69 –0.04 0.58 0.1% 10.96 1.20 0.30 0.86 1.08 0.25 –0.15 0.7% 7.1% –1.7% –0.38 1.69 0.3% 17.1% 0.19 3FM 8.09 0.5% 9.8% 17.0% 9.1% –0.5% 7.31 –0. and value beta (β iV) estimated from expression (5) in the second.41 –0.2% 7. and fourth columns.7% 4.51 –0.95 0. All betas estimated with monthly data over the Jan/05-Dec/09 period.2% 7.18 0.60 0.12 –1.70 –0.58 –0.87 0.17 –0.30 0.1% 7.60 0.Table 2 The 3FM.6% –0.8% 1.67 –0.5% 1.2% 12.35 –0.78 0.4% 16. third.79 –0.00 –0.7% 8.01 0.7% –0.7% 14.81 0.3% 5.66 2.4% –0.03 0.64 0.48 0.82 1.27 –0.51 0.5% 9.55 –0.95 βiS 0.32 –0.75 1.36 0.1% 6.1% –1.18 –0.24 2.38 –0.5% –0.30 2.5% –0.02 0. The last three rows show.7% 9.81 0.2% 7.8% 10.64 0.0% 10.8% 17. the lowest (Min).50 –0.22 βiV 0.56 0. SMB.2% 7.7% 9.1% 10.44 –0.24 1.5% 17.58 –0.21 1. highest (Max) and average (Avg) value of each magnitude. The monthly return of all companies is net of the monthly risk-free rate.29 –0.45 0.1% 6.72 1.2% 7.0% 7.37 0. and the cost of equity that follows from expression (6) in the fifth column.30 0.7% Diff 0.68 –0. Data for the MRP . The last column shows the differences (Diff) between the fifth and the seventh columns.0% –1.55 1.5% 9.7% 7.10 0.0% 6.71 0.30 –0.4% 5.43 0.8% –0.61 0.15 –0.72 –0.16 0. for the 30 companies in the Dow in the first column.30 0.3% 9.7% 9.3% 10. and the cost of equity that follows from expression (6) in the seventh column.

246 0. but they seem to be the exception rather than the rule. at least partially. a negative exposure to the size premium (a negative size beta) indicates a company whose returns tend to fall when the outperformance of small stocks (relative to large stocks) increases. the estimates of BH’s alpha. although these costs of equity were estimated using the same risk-free rate and MRP as those used for the 3FM. To be sure. Most alternative models. and the returns for the MRP. third. the market betas estimated with the 3FM (0. This is an important insight of the 3FM so let’s put it in a different way to make sure the idea is clear. this is exactly what we would expect to find in the case of large companies and growth companies. Importantly. and value beta (βV) from expression (5). SMB.000 β βS βV Adj. there are substantial differences in a few cases (American Express. the (market) betas are not the same as those estimated from the 3FM. and a negative value beta indicates a company whose expected return is inversely 82 Journal of Applied Corporate Finance • Volume 23 Number 2 affected by an increase in the outperformance of value stocks relative to growth stocks. A positive exposure to the size premium (a positive size beta) indicates a company whose returns tend to increase when the outperformance of small stocks (relative to large stocks) increases. The argument for positive and negative value betas runs along similar lines. is easy to understand.5% according to the 3FM and 9. as Table 2 clearly shows. and HML). This is the case because when estimating betas with the CAPM. and easy to implement. BH’s returns are net of the monthly risk-free rate.Table 3 The 3FM. including the 3FM. SMB. and their intuition is not always clear. and the last column confirms. Model Panel A: The CAPM Coefficient p-value Panel B: The 3FM Coefficient p-value α 0. As you can see. and because the 3FM assumes that small stocks are riskier than large stocks. Furthermore.712 0. Bank of America. it is far from unusual to find negative size betas and value betas. This is so because a negative size beta indicates a company whose expected return is inversely affected by an increase in the outperformance of small stocks relative to large stocks.dj-R2 0. in most cases the differences are not substantial. The cost of equity of the 30 companies in the Dow that follow from these betas and expression (6) are shown in the fifth column. Conversely. Finally.000 –0. are more demanding in terms of data collection. but on average across all 30 companies the required return from both models is virtually identical. the popularity of the CAPM? Note that the CAPM is widely taught in business schools. Monthly returns for the MRP . All coefficients estimated on the basis of monthly returns over the Jan/1977-Dec/2009 period. Before we discuss the estimates from the 3FM. In fact. that is. SMB. the CAPM.001 0. in panel A. and because the 3FM assumes that large stocks are less risky than small stocks.028 0. compare company by company the required returns in the fifth column of Table 2 (estimated with the 3FM) with those in the seventh column (estimated with the CAPM).000 0. Could this explain.011 0. size beta (βS). the required return on the company decreases. and in panel B. Merck). five years of monthly returns (Jan/05-Dec/09). 9. As the last line of Table 2 shows.99) are very similar. note that the sixth and seventh columns of Table 2 show the beta and the cost of equity of the same 30 companies estimated with the CAPM.7% according to the CAPM.235 We will estimate these three betas using expression (5). there are a few cases in which the difference is considerable (American Express. whereas when doing so with the 3FM there are three explanatory variables (MRP. JPMorgan Chase).95) and the CAPM (0. Let’s start by noting that the market betas estimated with the 3FM are in most cases very similar to those estimated with the CAPM. To be sure. market beta.807 0. But also of note is that although it is nearly impossible to find negative market betas. and fourth columns of Table 2. more difficult to implement. the estimates of BH’s alpha (α) and market beta (β) from expression (7).001 0. and HML portfolios downloaded from Ken French’s web page.316 0. the differences between the required returns calculated from these two models are often well within the differences we A Morgan Stanley Publication • Spring 2011 .012 0. MRP is the only explanatory variable. The betas estimated this way are shown in the second.201 0. the returns of all companies net of the monthly risk-free rate. and Excess Returns  This exhibit shows. and HML portfolios downloaded from French’s web page. are not always taught in business schools. on average. the required return on the company increases.

In other words. To estimate the exposure of BH shareholders to the market. it was conceived as a measure of risk-adjusted performance relative to the market. on companies that he believes are cheap relative to their fundamentals.712) shows that BH actually mitigated the effects of market’s fluctuations. The estimate of α measures outperformance or underperformance on a risk-adjusted basis.8%. Needless to say.7% annualized return of the S&P500. This magnitude is a measure of performance that adjusts a fund’s observed returns by its exposure to market risk. and within the range of differences found when making different choices for the inputs of the CAPM.7%. we should penalize Buffett’s performance for a positive exposure to the value premium. the market on a risk-adjusted basis was to calculate the fund’s alpha (α). On the other hand. BH’s monthly returns net of the monthly risk-free rate) and the independent variable is the market risk premium (MRP) taken from Ken French’s web page. a fund with a positive alpha indicated that. as expected. the company managed by Warren Buffett. which is a measure of Buffett’s risk-adjusted outperformance. the size premium (SMB) and the value premium (HML) all taken from Ken French’s web page. The dependent variable is BH’s risk premium (that is. outperforming the market by 13 percentage points over a period of more than 30 years has earned Buffett the reputation he has and surely deserves. in portfolio management and performance evaluation.864 by the end of 2009. True.316).10 First. or an arithmetic or geometric average market risk premium. Buffett also concentrates his portfolio on large companies (at least as far as publicly traded companies is concerned). and a fund with a negative alpha indicated the opposite. it would certainly pay to consider both models and choose the more appropriate.457.would find between a short-term and a long-term risk-free rate. This in turn implies that Buffett’s outperformance is even larger than that indicated by the 13 percentage points in terms of returns.3% of the S&P500. Importantly. indicating that we should “reward” Buffett for a negative exposure to the size premium and “penalize” him for a positive exposure 10. when implementing the CAPM. Thus. Before the introduction of the 3FM in the early 1990s. those who invested the same $100 in BH instead would have found themselves with $111. estimated with monthly data over the Jan/1977-Dec/2009 period. Over time. alpha. if the differences in required returns were substantial. substantially outpacing the 10. that is.8 percentage points) in terms of risk-adjusted returns. To illustrate this application of the 3FM. the fund had outperformed the market. the CAPM is the standard choice and the 3FM is only an increasingly popular alternative. the 3FM has become the standard tool used to estimate excess returns. considerably higher than the 15. To estimate alpha we run the regression R it – R ft = α + β1∙MRPt + ut . BH shareholders were subject to an annualized volatility of 24. the standard way to determine whether a fund outperformed 9. As stated earlier. using monthly data over the Jan/1977-Dec/2009 period. Journal of Applied Corporate Finance • Volume 23 Number 2 A Morgan Stanley Publication • Spring 2011 83 . although those who invested $100 in the S&P500 at the beginning of 1977 would have found themselves with $2. alpha came to be used also as a measure of return performance relative to the chosen benchmark. This is what panel B of Table 3 shows. Originally. the estimate of β1 measures the fund’s exposure to market risk. A positive alpha indicates that the fund outperformed the market in terms of risk-adjusted returns. the size beta is negative (–0. (7) where the notation is just as defined earlier in expression (5). and a fund with a negative alpha indicates the opposite.9 The estimated beta (0. has two slightly different interpretations. On the other hand. let’s consider Berkshire Hathaway (BH).246) and the value beta is positive (0. because the 3FM assumes that value stocks are riskier than growth stocks. note that. we need to run a regression just like (5). over the 1977-2009 period. However. it can be higher or lower than 1. perhaps the need for an alternative model (such as the 3FM) decreases considerably. a fund with a positive alpha is one that delivered a higher return than the benchmark against which its manager is evaluated. In other words. and by an even larger margin (14. Buffett concentrates his portfolio on value stocks. not necessarily the market. and a negative alpha indicates the opposite. as is well known.8%. Buffett outperformed the market by 13 percentage points in terms of returns. On the other hand. the vast majority of practitioners claim to use the CAPM to estimate the cost of equity. we should “reward” Buffett’s performance for a negative exposure to the size premium. and value risk premiums. but if the differences are small. During the 33-year period between 1977 and 2009.012) we obtain 14. In fact. Panel A of Table 3 shows the estimates of BH’s alpha and beta from expression (7). BH shareholders obtained an annualized return of 23. after adjusting its returns by its risk. and the 3FM assumes that large companies are less risky than small companies—and on that basis. indicating that the fund amplifies or dampens the market’s fluctuations. But first a caveat: The variable at the center of this section. size. Application 2 – Estimating Excess Returns As already noted. For that specific corporate finance purpose. BH’s monthly returns net of the monthly risk-free rate) and the independent variables are the market risk premium (MRP). The dependent variable is BH’s risk premium (that is. Thus. if we annualize the estimated alpha (0.

Although its popularity has been steadily increasing over time. For these reasons. 84 Journal of Applied Corporate Finance • Volume 23 Number 2 A Morgan Stanley Publication • Spring 2011 . when risk is assessed with three factors rather than with just one. In fact. and other countries quite clearly shows that size and value do matter. many competing models have been proposed to replace it. and its outperformance a bit lower.011) is very similar to that in panel A. and ultimately to provide a more reliable estimation of required returns. understand. small stocks tend to outperform large stocks. As long as practitioners believe (and they generally do believe) that small companies are riskier than large companies. these sources of risk should be taken into account when calculating required returns. and “penalizing” his performance for a positive exposure to the value factor. In other words. the jury is still out on whether the 3FM is a better model than the CAPM in the sense of estimating more accurate required returns. he still outperformed the market by over 14 percentage points over a 33-year period. particularly the latter. In other words. the size premium. The market beta (0. This example illustrates how the 3FM is now used in portfolio management and performance evaluation. Note that the “penalty” for exposure to the value factor is only a bit larger than the “reward” for the negative exposure to the size factor. There is little doubt that this model has become an important tool in any practitioner’s toolkit. the 3FM articulates the market risk premium. The CAPM makes the strong statement that the only variable that should have an impact on an asset’s required return is the asset’s beta. which is a measure of Buffett’s risk-adjusted outperformance when risk is assessed not only with respect to the market factor but also with respect to both the size and the value factors. the alpha estimated from the 3FM is a bit lower than that estimated from the CAPM. calculating alphas based on the 3FM has become the standard way to assess the performance of portfolio managers. the CAPM remains the standard model used by academics and practitioners to estimate required returns. Be that as it may. javier estrada is Professor of Finance at the IESE Business School in Barcelona. and the value premium into a model that aims to assess risk in a more comprehensive way. But at present. and know how to apply the 3FM. in the long term. and value stocks tend to outperform growth stocks. evidence from both the U. after “rewarding” Buffett’s performance for mitigating market risk for its negative exposure to the size factor. and still indicates that BH mitigated the effects of market volatility.1%. Note also that the market beta estimated from the 3FM is a bit higher than that estimated from the CAPM. However. The estimated alpha (0. Under the assumption that size and value are risk factors. and value stocks riskier than growth stocks.S. BH was a bit riskier.to the value premium. An Assessment Ever since the CAPM was introduced in the 1960s. practitioners should be aware of.807) is only a bit higher than it is in panel A. the 3FM has become an increasingly accepted alternative in both corporate finance and portfolio management applications. If we annualize this number we get 14. that is. That being said.

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