THREE FACTOR MODEL:

FAMA AND FRENCH (1992)

Oren Hovemann
Yutong Jiang
Erhard Rathsack
Jon Tyler
Cross Section of Expected Returns

A Firms Size and its Book/Market ratio combine to become a

strong predictor of the Firms expected return
The value of Beta as a predictor of return is challenged
Additional known factors used to predict stock returns are the
firms Leverage and Earnings/Price ratios
Size and B/M absorb the roles of Leverage and E/P ratios in
the Three Factor Model
Pricing Data

Pricing data includes stocks from:

NYSE

AMEX

NASDAQ

Date Ranges from 1962 to 1989

Data collected from CRSP and COMPUSTAT
Historical reporting of Book Value limits data range
Financial Reporting vs. Returns
Matching of returns with accounting data has a six month minimum gap.
December accounting values are used to calculate (t 1)
Book/Market

Leverage

Earning/Price

June accounting values are used to calculate (t)

Size (price factor)

The six month gap between financial reporting and realized returns insure
the reflection of all information into the stock pricing
Different fiscal year-ends between firms complicate the timing of matching
accounting values with returns
100 SizeBeta Portfolios

Portfolio Assignments
First stocks are divided into Size ranked deciles

Then each Size based decile is sub-divided into Pre-Ranked Beta deciles

A stock can move between portfolios over time if either its size or pre-
ranked Beta changes
Estimated Betas for each Portfolio
Historical monthly returns are regressed against CRSP derived market
returns to estimate Post-Ranked Betas
Estimated Betas for portfolios based on a Size-Beta ranking magnify the
range of Beta values
Allows tests that distinguish between the effects of size and beta upon
stock returns
Size-Beta Portfolios increase range of
estimated Betas

Size based beta variation is 1.44 0.92 = 0.52

Size-Beta Portfolio based beta variation is 1.79 0.53 = 1.26
The range of variation of Beta in Size-Beta based Portfolios is 1.26 / 0.52
= 2.4 times greater than Size based portfolios
Table II
Strong negative relation between size and average
return.
Strong positive relation between average return
and beta.
Table II
Table II
 No relation between average return and beta
during the 1964-1979 period.
 Table III
Firm size ln(ME) is measured in June of year t
If earnings are positive, E(+)/P is the ratio of total earnings to market equity
and E/P dummy is 0.
If earnings are negative, E(+)/P is 0, E/P dummy is 1.
T-statistic is the average slope divided by its time-series standard error.
Fama-Macbeth Regressions
The Fama-Macbeth regression is a method used to estimate
parameters for asset pricing models.
The method estimates the betas and risk premium for any risk
factors that are expected to determine asset prices.
The method works with multiple assets across time (panel data).
 The parameters are estimated in two steps:
First regress each asset against the proposed risk factors to
determine that asset's beta for that risk factor.
Then regress all asset returns for a fixed time period against
the estimated betas to determine the risk premium for each
factor.
Table III
 Size helps explain the cross-section of average
stock returns.
Market beta does not help explain average stock
returns for 1963-1990
 Table IV
Portfolios ranked by values of book-to-market
equity (BE/ME) and earnings-price ratio (E/P)
13 portfolios formed with the lowest and

highest portfolios split and stocks with negative

E/P in a separate portfolio (only for E/P)
Negative BE firms not included (on average,
there are about 50/2317 per year)
 Table IV
Properties of Portfolios Formed on Book-to-Market Equity
(BE/ME)
 Table IV
Properties of Portfolios Formed on Earnings-Price Ratio
(E/P)
 Variables in Table IV
Return Time-series average of the monthly equal-weighted
portfolio returns (%)
Time-series average of the monthly portfolio Bs
Ln(ME) Market equity representing firm size (outstanding shares
x share price)
Ln(BE/ME) Book equity divided by market equity
Ln(A/ME) - Book assets divided by market equity
Ln(A/BE) Book assets divided by book equity
E/P dummy Dummy variable used to distinguish between
positive and negative earnings
E(+)/P Positive earnings to price ratio
Firms average number of stocks in the portfolio each month
 Average Returns
Average returns sorted by BE/ME
Strong positive relationship
Difference of 1.53% from lowest to highest portfolios
Unlikely a effect
Negative BE and high BE/ME have similar returns as a result
of capturing relative distress
Average returns sorted by E/P
Returns have a U shape
Portfolio 0 (negative earnings) has higher than average
returns
Returns increase as positive E/P portfolios increases
 Table IV
Properties of Portfolios Formed on Book-to-Market Equity
(BE/ME)
 Table IV
Properties of Portfolios Formed on Earnings-Price Ratio
(E/P)
 BE/ME
Monthly regressions of returns on book-to-market
equity has strong relationship
More significant than the size effect
Book-to-market equity does not replace size
Monthly returns of regressions on book-to-market equity
and size:
Size has a slope of -.11 and a t-statistic of -1.99
Book-to-market equity has a slope of .35 and a t-statistic of
4.44
 Table III
Average Slopes (T-Statistics) from Month-by-Month Regressions of Stock
Returns on , Size, Book-to-Market Equity, Leverage, and E/P
 Leverage
Two leverage ratios are used
A/ME (book assets to market equity) - Measure of
market leverage
A/BE (book assets to book equity) - Measure of book
leverage
Both leverage ratios are related to average returns,
with opposite signs but similar absolute values
The difference between these ratios is what helps
explain average returns
 Table III
Average Slopes (T-Statistics) from Month-by-Month Regressions of Stock
Returns on , Size, Book-to-Market Equity, Leverage, and E/P
 Leverage & Book-to-Market
ln(BE/ME) = ln(A/ME) ln(A/BE)
Close link between leverage and BE/ME
Two interpretations:
High book-to-market ratio could be low stock price
compared to book value
High book-to-market ratio could be a firms market
leverage is high relative to its book leverage
Relative distress (captured by BE/ME) can also be
viewed as a leverage effect (captured by the
difference between A/ME and A/BE)
 E/P
It is believed that earnings are a proxy for future
earnings
E/P dummy is used because negative earnings are not a
proxy for future earnings
E/P dummy (negative earnings) has a strong
relationship with returns
Add size to the regression and the relationship becomes
insignificant
This shows that the high returns for negative E/P is better
explained by size
E(+)/P has a strong relationship with returns
 Table III
Average Slopes (T-Statistics) from Month-by-Month Regressions of Stock
Returns on , Size, Book-to-Market Equity, Leverage, and E/P
 Table IV
Properties of Portfolios Formed on Earnings-Price Ratio
(E/P)
 E/P & Book-to-market
Regressions of returns on ME, BE/ME and E/P gives
insignificant results for E/P
Regressions of returns using ME, BE/ME and E/P
produce very similar results to regressions using just ME
and BE/ME for ME and BE/ME
Suggests that E/P is insignificant in explaining returns when
book-to-market ratios are used
Results suggest that the relationship between E(+)/P
and average return is mostly due to the positive
correlation between E/P and BE/ME
Firms with high E/P have high book-to-market ratios
IV. A Parsimonious Model For Average
Returns
1) When we allow for variation in that is unrelated to size,
there is no reliable relation between and average return
2) The opposite roles of market leverage and book leverage in
average returns are captured well by book-to-market equity
3) The relation between E/P and average return seems to be
absorbed by the combination of size and book-to-market
equity.

Do not use
Size and book-to-market equity are better indicators
A. Average Returns, Size and Book-
to-Market Equity
A) Controlling for size, book-to-market equity
captures substantial variation in average returns
B) Controlling for BE/ME leaves a size effect in
average returns.
A. Average Returns, Size, and Book-to Market Equity

Table V: Average Monthly Returns on Portfolios Formed on Size

and Book-to-Market Equity; Stocks Sorted by ME (Down) and then
BE/ME (Across): July 1963 to December 1990

0.58% per month average spread of returns

B. The interaction Between Size and
Book-to-Market Equity
Low Market Equity
Low stock prices
High book-to-market equity
Table III
Correlation between ln(ME) and ln(BE/ME) = -0.26
C. Subperiod Averages of FM Slope

Table III
Sizehas a negative premium
Book-to-Market has a positive premium

Market has a neutral 0 premium

Table VI
Subgroups created and tested with FM Slope
weak and inconsistent

Size Effect lacks power

Book-to-Market consistently reliable

January Effect also found to be significant

D. and the Market Factor:
Caveats
Average premiums for , size, and book-to-market
equity depend on the definitions of the variables
used in the regressions.
UsingB/E will change slope
SLB model
Overturns simple relationship between return and being
flat
Leaves as the only variable
V. Conclusions and Implications
Sharpe-Linter-Black (SLB) Model
Positive
simple relation between average return and
market (1926-1968)
Reinganum (1981) and Lakonishok and Shapiro
(1986)
(1963-1990)
V. Conclusions and Implications
What variables can explain return?
Banz (1981) Strong Negative Relationship between
return and firm size
Bhandari (1988) Positive Relationship between return
and leverage
Basu (1982) Positive Relationship between return and
E/P
Rosenberg, Reid and Lanstein (1985) Positive
Relationship between return and book-to-market equity
Chan, Hamao, and Lakonishok (1992) find that BE/ME
is powerful for predicting returns
A. Rational Asset-Pricing Stories
What is the economic explanation for the roles of size and book-to-market
equity in average returns?
Regression on returns in ln(ME) and Ln(BE/ME) are returns on portfolios
that mimic the underlying common risk factors in returns proxied by size
and book-to-market equity.
Relation between size and average return proxies for a more
fundamental relation between expected returns and economic risk
factors.
Relation between size and average return is a relative-prospects effect.
More distressed firms are more sensitive to economic conditions
BE/ME should be a direct indicator of the relative prospects of a firm
Low BE/ME strong performance
B. Irrational Asset-Pricing Stories
Asset pricing effects are not always rational
Market overreaction to the prospects of the firm
C. Applications
Size and Book-to-market equity describe the cross-
section of average stock returns.
Willit persist?
Does it result from rational or irrational asset-pricing?

Explanatory power does not deteriorate over time

Long-term average returns

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