101 Concepts for the Level I Exam

Essential Concept 45: Estimating Required Return on Equities

The CAPM is the widely used for estimating required return.

Required return:

$\mathrm{E}\left({\mathrm{R}}_{\mathrm{i}}\right)\mathrm{=}{\mathrm{R}}_{\mathrm{F}}\mathrm{+\ }{\mathrm{\beta }}_{\mathrm{i}}\left[\mathrm{E}\left({\mathrm{R}}_{\mathrm{M}}\right)\mathrm{-}{\mathrm{R}}_{\mathrm{F}}\right]$

The Fama–French model (FFM) is a three-factor model; it adds two premiums in addition to the equity risk: a size factor, and a value factor.

${\mathrm{r}}_{\mathrm{i}}\mathrm{=}{\mathrm{R}}_{\mathrm{F}}\mathrm{+\ }{\mathrm{\beta }}^{\mathrm{mkt}}_{\mathrm{i}}\mathrm{\ RMRF+}{\mathrm{\beta }}^{\mathrm{size}}_{\mathrm{i}}\mathrm{\ SMB+\ }{\mathrm{\beta }}^{\mathrm{value}}_{\mathrm{i}}\mathrm{\ HML}$

The Pastor-Stambaugh model is an extension to the FFM; it adds a fourth factor for liquidity.

Build up models are similar to risk premium approaches, however they do not use betas to adjust for exposures to factors. An example is the bond yield plus risk premium approach, which is used to value the equity of companies with publicly traded debt.

Cost of equity = YTM on the company’s long-term debt + risk premium (often 3 to 4 percent)

Strengths and weaknesses:

The CAPM model is simple to use but it describes risk incompletely as multiple factors other than equity market factor drive returns.

FFM views size and value factors as compensation for risk. But, in reality, they result from market inefficiencies than act as compensation for systematic risk.