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The Three‐Factor Model: A Practitioner's Guide
Author(s) -
Estrada Javier
Publication year - 2011
Publication title -
journal of applied corporate finance
Language(s) - English
Resource type - Journals
eISSN - 1745-6622
pISSN - 1078-1196
DOI - 10.1111/j.1745-6622.2011.00329.x
Subject(s) - cost of equity , value premium , capital asset pricing model , risk premium , economics , valuation (finance) , cost of capital , portfolio , financial economics , risk–return spectrum , capitalization , expected return , market capitalization , equity premium puzzle , market value , estimation , market portfolio , econometrics , actuarial science , finance , stock market , microeconomics , profit (economics) , paleontology , linguistics , philosophy , management , horse , biology
The three‐factor model (3FM) has slowly but steadily become a popular alternative to the CAPM for measuring risk from the perspective of both corporate finance and portfolio management. The evidence clearly shows a negative relationship between market capitalization and returns, and a positive relationship between the book‐to‐market ratio and returns. Under the assumption that size and value are risk factors, the 3FM incorporates a market risk premium, a size premium, and a value premium into a model that aims to assess risk in a more comprehensive way, and ultimately to provide a more reliable estimation of required return. The required return produced by the 3FM has corporate finance applications (such as cost of capital estimation, project evaluation, and firm valuation) as well as portfolio management applications (such as performance evaluation). This article discusses the foundations and intuition behind the 3FM, as well as its application to the estimation of the cost of equity and excess returns.