2. Problem
The relationship between risk and return has long
been a topic for discussion and research.
Investors and investment managers seek
financial models that quantify risk and translate
that risk into estimates of expected return on
equity (Mullins, 1982).
3. Fama French Five factor model
The Fama-French five-factor model which added two
factors, profitability and investment, came about after
evidence showed that the three-factor model was an
inadequate model for expected returns because it’s
three factors overlook a lot of the variation in average
returns related to profitability and investment (Fama and
French, 2015).
4. History
• In the beginning, 1964, the single-factor model also known as the capital asset pricing
model was developed
• This single factor was beta and it was said that beta illustrated how much a stock moved
compared to the market. Stocks that moved more than the market had a higher beta and
thus higher risk and return (DeMuth, 2014).
• In 1993, Fama and French came up with the three-factor model with its two additional
factors being size and value (e.g. book to market value). The three-factor model was a
significant improvement over the CAPM because it adjusted for outperformance tendency.
5. Fama French three factor model
• Nobel Laureate Eugene Fama and researcher Kenneth French, former
professors at the University of Chicago Booth School of Business,
attempted to better measure market returns and, through research,
found that value and small cap stocks outperform markets on
regular basis.
6. Factors
Size Factor:
Small Minus Big (SMB)
Small minus big (SMB) is a factor in the Fama/French stock
pricing model that says smaller companies (Capitalization)
outperform larger ones over the long-term.
The argument is that smaller firms typically are more nimble and
able to grow much faster than larger companies.
Small-cap stocks also tend to be more volatile and riskier for
investors than large-cap stocks.
Small firms vs neglected firms
7. Factor
Value Factor
High minus Low
High Minus Low (HML), also referred to as the value
premium
HML accounts for the spread in returns between value
stocks and growth stocks.
This factor argues that companies with high book-to-market
ratios, also known as value stocks, outperform those with lower
book-to-market values, known as growth stocks.
Value Stocks vs Growth stocks
8. Difference b/w Value and Growth Stock
Value Stock:
A value stock refers to shares of a company that
appears to trade at a lower price relative to
its fundamentals, such as dividends, earnings, or
sales, making it appealing to value investors
A value stock is a security trading at a lower price
than what the company’s performance may otherwise
indicate. Investors in value stocks attempt to
capitalize on inefficiencies in the market, since the
price of the underlying equity may not match the
company’s performance
9. Difference b/w Value and Growth Stock
Growth stock:
Growth stocks are those companies expected to grow
sales and earnings at a faster rate than the market
average.
Growth stocks often look expensive, trading at a high
P/E ratio, but such valuations could actually be
cheap if the company continues to grow rapidly
which will drive the share price up.
Growth stocks typically don't pay dividends.
10. Fama French three factor model
The model was developed by Nobel laureates Eugene Fama
and his colleague Kenneth French in the 1990s.
The model is the result of an econometric regression of
historical stock prices.
But, it did not explain some anomalies nor the cross-
sectional variation in expected returns particularly related to
profitability and investment (ValueWalk, 2015).
12. Researchers have expanded the Three-Factor model in
recent years to include other factors. These include
"momentum," "quality," and "low volatility," among
others.
13. Fama French Five factor model
The Fama-French five-factor model which added two factors,
profitability and investment, came about after evidence showed that
the three-factor model was an inadequate model for expected
returns because it’s three factors overlook a lot of the variation in
average returns related to profitability and investment (Fama and
French, 2015).
14. Factors (Additional)
Profitability:
Robust minus Weak (RMW)
companies reporting higher future earnings have higher returns in the
stock market
Robustness of Profit is ( Revenues - COGS – (General.Selling.Admin).
Expenses - Initial Expense) / Total Stock holder’s Equity
Investment:
Conservative minus Aggressive (CMA)
the difference between the returns of firms that invest conservatively
and firms that invest aggressively.
internal investment and returns, suggesting that companies directing
profit towards major growth projects are likely to experience losses in
the stock market.
15. Application of the Fama French 5 factor model
The theoretical starting point for the Fama-
French five-factor model is the dividend
discount model as the model states that the
value of a stock today is dependent upon future
dividends. Fama and French use the dividend
discount model to get two new factors from it,
investment and profitability (Fama and French,
2014).
16. Dividend discount model
The dividend discount model (DDM) is a quantitative
method used for predicting the price of a company's stock
based on the theory that its present-day price is worth the
sum of all of its future dividend payments
when discounted back to their present value.
It attempts to calculate the fair value of a stock irrespective
of the prevailing market conditions and takes into
consideration the dividend payout factors and the market
expected returns.
Under valued stock vs Over valued stock
If the value obtained from the DDM is higher than the current trading price of
shares, then the stock is undervalued and qualifies for a buy, and vice versa.
17. Equation / Formula
With the addition of profitability and investment factors, the five-factor model time
series regression has the equation below:
Rit — RFt = ai + bi(RMt — RFt) + siSMBt + hiHMLt + riRMWt + ciCMAt + eit
Where:
Rit is the return in month t of one of the portfolios
RFt is the riskfree rate
Rm - Rf is the return spread between the capitalization-weighted stock market
and cash
SMB is the return spread of small minus large stocks (i.e. the size effect)
HML is the return spread of cheap minus expensive stocks (i.e. the value effect)
RMW is the return spread of the most profitable firms minus the least profitable
CMA is the return spread of firms that invest conservatively minus aggressively
(AQR, 2014)
18. Practicality
of the theory
Portfolio formation using the Fama-French
five-factor model with modification of a
profitability variable: An empirical study
on the Indonesian stock exchange
C. Hapsari & G.H. Wasistha
Department of Accounting, Faculty of Economics
and Business, Universitas Indonesia, Depok,
Indonesia
19. Abstract
This study aims to analyze portfolio formations using the
Fama-French five factor model with a modification on the
profitability variable.
Different portfolio formations are performed for three kinds
of profitability variables, which are annual operating profit
per total equity (RMW), monthly operating profit per total
equity (ROE) and annual operating profit per total assets
(ROA).
The method used in this study is based on the Fama and
French (2015) five-factor model. The result shows that the
portfolio formation for the RMW variable has the highest
impact on stock return. This result is consistent with the
results of Fama and French (2015). This result means that it
would be better to use annual operating profit per total
equity as the proxy for profitability.
20. Hypothesis
H1: Portfolio formation using the RMW variable is better
than portfolio formation using the ROE variable as a
profitability proxy to stock return
H2: Portfolio formation for the RMW variable is better
than portfolio formation for the ROA variable as a
profitability proxy to stock return.
21. Portfolio formation
The steps of the portfolio formation for the three models were:
1. Data of stock return portfolio from 316 companies are arranged based on
capitalization value.
2. Stock portfolio is divided into two sizes based on capitalization: small and
big.
3. The small size stock portfolio to be rearranged later into three parts based
on the BE/ ME ratio, 30% lowest, 40% medium and 30% highest. The big size
stock portfolio will also be arranged into three parts based on the BE/ME
ratio, 30% lowest, 40% medium and 30% highest.
4. The small size stock portfolio will be arranged based on market premium,
investment and profitability into three parts, 30% lowest, 40% medium and
30% highest. The same treatment also applies to the big size stock portfolio.
5. Profitability factor will be arranged based on three variable types used in
this research, which are RMW, ROE, and ROA
22. Analysis and conclusion
A normality test, multicollinearity test and heteroscedasticity test
are performed, and no irregularity is found.
This research concludes that all of the three profitability variables
used in this research model have a positive effect on stock return.
That means that the portfolio formation for RMW, ROE and ROA
has a positive coefficient.
From the models used in this research, the RMW variable is better
than the ROE variable in representing profitability. This is related
to the Fama and French (2015) FF5F Model, which is based on the
Dividend Discount Model. Fama and French (2015) use the data of
the yearly operating profit because the data already includes
dividend information that is not included in the monthly operating
profit data.
23. EMPIRICAL TESTING OF THE FIVE-FACTOR MODEL OF
FAMA AND FRENCH IN INDONESIA AS AN EMERGING
CAPITAL MARKET
Mustaruddin Saleh
Department of Management, Faculty of
Economics and Business, Tanjungpura University,
PONTIANAK.
DOI: 10.31014/aior.1992.03.01.175
24. Abstract
This study was conducted to empirically examine the five-factor
model of Fama and French in respect to stock returns of
companies listed in the finance sector with 170 observations over
the period 2012-2016. As a comparative analysis, this study is also
conducted to examine CAPM and the three-factor model of Fama
and French. The findings of the study revealed that the market
return has a positive and partially significant impact on the stock
return for CAPM. Specifically, both variables, small minus big
(SMB) and high minus low (HML) have a positive and significant
impact on stock returns in the three-factor model and five-factor
model of Fama and French. In contrast to the research of Fama
and French the explanation power of the five-factor model is lower
than that of the three-factor model in this research.
25. Problem statement
(1). Can the variation in the rate of return of shares on Indonesia’s
Stock Exchange be explained by CAPM?
(2). Can the variation in returns on shares on Indonesia’s Stock
Exchange be explained using the three-factor model of Fama and
French?
(3). Can the variation in the rate of return of shares on Indonesia’s
Stock Exchange be explained using the five-factor model of Fama and
French?
26. Research Method
The population in this study is public companies listed in
the Financial Sector of Indonesia’s Stock Exchange for a
period of 5 years from 2012 to 2016. The research
samples were taken by purposive sampling. In the
estimation method the regression model using panel
data can be done through three tests; to compare the
performance of the CAPM with the three-factor model
of Fama and French, and then five-factor model from
Fama and French. This method can use the ordinary
least squares (OLS) approach or the least squares
technique to estimate the panel data model.
27. Results
Only two of the five model variables; namely, the Small Minus
Big variable (SMB), as a proxy for company size (Size), and the
High Minus Low variable (HML), as a proxy for Book Value to
Market Value (BE/ME), have a positive and significant effect
on the rate of return of shares of companies in the financial
sector.
In addition, the profitability factor (PF) and investment
variable (Invst) in the five-factor model Fama and French
have a negative effect but are not significant on the rate of
return of shares of companies in the financial sector.
28. Conclusion
• The Fama French 5 factor model has yet to be
proven as an improvement compared to
previous models however it has left room for
better models to be further developed from it
in the future.
• Most investors still use the famous three-
factor model but as methods seem to take
some years before people start using, as
industry personnel always have doubts.
29. References
https://en.wikipedia.org/wiki/Fama%E2%80%93French_three-factor_model
Fama, E. F.; French, K. R. (2015). "A Five-Factor Asset Pricing Model". Journal of
Financial Economics. 116: 1–
22. CiteSeerX 10.1.1.645.3745. doi:10.1016/j.jfineco.2014.10.010.
https://www.investopedia.com/terms/f/famaandfrenchthreefactormodel.asp
DOI: 10.31014/aior.1992.03.01.175
https://blog.quantinsti.com/fama-french-five-factor-asset-pricing-model/
https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library/f-
f_5_factors_2x3.html
