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Fama-French Three-Factor Model

The Fama-French three-factor model is based on the pioneering work of Dr. Eugene F. Fama and Dr.
Kenneth R. French. The origin of the model is an empirical study conducted by Dr. Fama and Dr.
French, the results of which are published in a 1992 paper entitled "The Cross-Section of Expected
Stock Returns." fn 4 Subsequent papers further supported the explanatory power of the Fama-French
three-factor model and its usefulness in developing cost of capital estimates. fn 5 fn 6 Among other things,
the papers challenge the relevance, and usefulness, of the CAPM in explaining differences across com-
panies in historical equity returns. Dr. Fama and Dr. French’s research indicates that two other factors,
firm size (as measured by market capitalization) and book-to-market ratio, do a better job of explaining
firm-level differences in average equity returns than a firm’s CAPM beta. However, Dr. Fama and Dr.
French continue to include a measure of a stock’s sensitivity to movements in the overall market — sim-
ilar to beta — as the third factor because it does a good job of describing how a stock’s risk premium
varies over time. A discussion regarding the use of the Fama-French model, and other multi-factor mod-
els, is beyond the scope of this practice aid.

Duff & Phelps Risk Premium Report

The Duff & Phelps Risk Premium Report (the Duff & Phelps Report) is an increasingly popular tool be-
ing employed by valuation practitioners to estimate the cost of equity capital. The primary data utilized
in the Duff & Phelps Report is the price of, and dividends on, publicly traded equity securities and fi-
nancial statement data for the applicable entities. The Duff & Phelps Report develops estimates of the
cost of equity capital by grouping the equity securities of companies traded on the New York Stock Ex-
change, the American Stock Exchange, and the NASDAQ into 25 different portfolios based on the size
of the publicly traded entities. The measurements of size are as follows:

1. Market value of equity;

2. Book value of equity;

3. 5-year average net income;

4. Market value of invested capital;

5. Total assets;

6. 5-year average EBITDA;

7. Sales; and

fn 4 Eugene F. Fama and Kenneth R. French, "The Cross-Section of Expected Stock Returns," Journal of Finance 47, no. 2 (June
1992): 427–486.

fn 5 Eugene F. Fama and Kenneth R. French, "Size and Book-to-Market Factors in Earnings and Returns," Journal of Finance 50, no.
1 (March 1995): 131–155.

fn 6 Eugene F. Fama and Kenneth R. French, "Industry Costs of Equity," Journal of Financial Economics 43, no. 2 (February 1997):
153–193.

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