TASK: Use the Fama-French Three Factors model to estimate the cost of equity for Walmart.

An example lesson to refer to is below (for Costco). To use the CAPM approach for Costco, let's assume that the risk-free
rate is about 2% (based on the 10-year Treasury yield in May 2013) and a Value Line for Costco of 0.75 (as of May
2013). With a market risk premium of 5%, the cost of equity kE for Costco is: 2% + 0.75 5% = 5.75%.
The FF Three Factors model: this model was developed by Fama and French (1995) and uses a time series regression of
monthly returns on 3 independent variables. Specifically, the regression model is as follows:
Equation 3.13: Ru

- Rft = i (Rmt - Rft) + (si SMBt) + (hi HMLt) + it

In Equation 3.13., the left hand side (dependent variable) is the monthly excess returns of stock i over risk-free rate of
return. The first independent variable on the right hand side of Equation 3.13., (R mt - Rft), is the monthly excess returns on
the market index. The second independent variable, SMBt, is the difference between monthly returns of small-cap stocks
and large-cap stocks. The third independent variable, HML t, is the difference in monthly returns between high book-tomarket stocks and low book-to-market stocks. The coefficients i, si, and hi measure the sensitivity of stock i's returns on
these three factors.
1. Estimating the cost of equity using this model uses the following equation:
Equation 3.14: kE = Rf +(i MRP) + (si SMBP) + (hi HMLP)
In Equation 3.14., MRP is the market risk premium. SMBP is the expected size premium estimated using
historical average annual returns on the small-cap and large-cap stocks. HMLP is the expected value premium
estimated using historical average annual returns on the high book-to-market and low book-to-market stock
portfolios. The coefficientsi, s i, and h i are estimated from the time series regression Equation 3.13.
2. The Ibbotson Beta Book (now published by Morningstar) contains an estimate of the FF coefficient, the SMB
premium, and the HML premium for each company. So, to compute kE using Equation 3.14., we only need to
get Rfand market risk premium (MRP). Rf is the yield on the Treasury bond and is available from the Federal
Reserve's website. The MRP is assumed to be between 4.5% and 5.5% based on the earlier recommendation by
Koller, Goedhart, and Wessels.
3. If you have no access to the Ibbotson Beta Book, then you need to run the time series regression Equation 3.13.
yourself. Five data series need to be collected: the monthly returns of stock i, market index, and risk-free rate, as
well as the monthly SMB and HML factor returns. You may get the historical price data for stock i from Yahoo!
Finance. Data on the other four series is available from Professor French's website. From his website, click the
U.S. Research Returns on the left panel (the first bullet point under Data Library). You will be directed to the
section that contains downloadable data files. Choose the Fama/French Factors, as shown by Figure 3.17., to
download a zip file that contains monthly data for four series needed to run time series regression Equation 3.13.

Figure 3.17. Fama-French Factor Downloadable File

4. Before running the time series regression, make sure that you have converted the historical price series that you
downloaded from finance.yahoo.com into a monthly returns series. Then, combining this monthly return series
with the monthly data for four series from Professor French's website into a single Excel file. Figure 3.18 displays
the combined file for Costco:

Figure 3.18. Time Series Regression Data

Note that the monthly data for Costco was downloaded for July 1986 through December 2012, but to conserve
space, rows 4-317 are not shown. Column C is the monthly returns series computed from column B which
contains the price series from finance.yahoo.com. Columns D through G contain monthly data series downloaded
from Professor French's website. Column H contains the difference between the monthly returns of Costco
(column C) and the risk-free rate (column G).
4. Run the time series regression Equation 3.13. with monthly series in column H as the dependent variable, and the
series in columns D, E, and F as the three independent variables. Let's use all the data series from August 1986
through December 2012, and set the constant equal to zero, as shown in the figure below:

Figure 3.19. Time Series Regression Data Options

Clicking OK will generate the following results:

Summary Output for Regression of Monthly Stock Excess Return on the Market Risk Premium, the SMB
Factor, and the HML Factor
Summary Output for Regression of Monthly Stock Excess Return on the Market Risk Premium, the SMB Factor,
and the HML Factor

Table 3.3. Value Line Variables

Variables

Coefficients

Standard Error

t Stat

P-value

Lower 95%

Upper 95%

Intercept

N/A

N/A

N/A

N/A

N/A

Mkt-RF

0.9251

0.0918

10.0804

0.0000

0.7446

1.1057

SMB

0.1389

0.1336

1.0396

0.2993

-0.1240

0.4017

HML

-0.2649

0.1423

-1.8619

0.0636

-0.5448

0.0150

4.

C
l

the hypertext links in the paragraph below to highlight sections in Table 3.3. You may need to scroll up to see the highlighted sections.

Note from the above results for Costco that the FF coefficient (coefficient for market risk premium - Note: this
link highlights data in Table 3.3.) is 0.9251. The coefficients si (for the SMB factor - Note: this link highlights data
in Table 3.3.) and hi (for HML - Note: this link highlights data in Table 3.3.) are 0.1389 and -0.2649,

i
c
k

respectively.The coefficient is highly statistically significant.The si coefficient is not significant, while

the hi coefficient is significant at the 10% level.
4. To estimate kE using the above regression results, let's assume like before that market risk premium is 5% and the
risk-free interest rate is 2%. The Fama/French Factors zip file downloaded earlier also contains the annual factors
for SMB and HML (located at the bottom of the file). The historical average SMB and HML premia (over the 19272012 period) are 3.48% and 5/16%, respectively. Given these values, kE = 2% + (0.9251 5%) + (0.1389 3.48%)
+ (-0.2649 5.16%) = 5.742%.

NOTE: The long-term average risk premium for the S&P 500 over the 10 year Treasury bond rate is 5.5%. We will
see that this average has risen slightly, to about 6.13% based on some recent revisions to the FF data. When
added to the current rf of 2.1%, this results in a current expected rm of approximately 8.23%. If the actual return
to the S&P 500 for the past year or six months is used to represent rm, this would not be an unbiased estimate of
the expected long-term return to the market, but rather a snap-shot of a specific short-term period.
As you calculate WalMarts COE in the future, keep these benchmarks in mind, as well as the difference between
return and risk premium to the market.