Running head: A REVIEW OF BARTHOLDY, J., & PEARE, P. (2005).

ESTIMATION OF
EXPECTED RETURN: CAPM VS. FAMA AND FRENCH

ARTICLE REVIEW
ESTIMATION OF EXPECTED RETURN: CAPM VS. FAMA AND FRENCH

Hani Kalsom binti Hashim

University Science Malaysia
2015
Estimation of Expected Return: Capm vs. Fama and French
In this paper, author compare the performance of one-factor model (CAPM) and Fama
and French three-factor model in estimating expected return for individual stocks. After
estimating individual stock returns using CAPM with different time frames, data frequencies and
indexes author found that 5 years of monthly data and equal-weighted index is different to the
commonly suggested value-weighted index, provide the best estimate. With average 3% of
variances in returns performance of the model is very poor. Then, author estimates with Fama
and French model using 5 years of monthly data and not much better; independent of the index
used, it explains on average 5% of differences in returns. These results will inevitably raise
questions about the use of either model for estimation of individual expected stock returns.
The two main alternatives available for estimation of expected return or cost of equity for
individual stocks are a single-factor model (or Capital Asset Pricing Model [CAPM]) and the
three-factor model suggested by Fama and French. Therefore the objective of this paper is to
compare the performance of the Fama French model with CAPM for individual stocks.
Furthermore the second objective is to find the best index, time frame, and data frequency for

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estimating beta, and therefore expected return, based on CAPM. Whether or not dividends
should be included in the returns and whether raw returns or excess returns should be used when
estimating beta are also examined. The finding suggested 5 years of monthly data are in fact the
appropriate time period and data frequency for estimation of beta. On top of that, an equal
weighted index, as opposed to the commonly recommended value-weighted index, provides a
better estimate also founded. It does not appear to matter whether dividends are included in the
index or not or whether raw returns or excess returns are used in the regression equation. Richard
Roll pointed out in his presidential address to the American Finance Association (Roll, 1988) that
the general performance of betaQ in explaining portfolio returns is not great. As discussed above
for many practical applications, it is individual returns that are relevant, so it is pertinent to ask
how well is CAPM explains returns on individual stocks. From the results obtained here, the
answer is once again not great.
Author highlighted the question is that of a firm estimating its cost of equity. Hence,
CAPM and Fama French, it is assumed that an estimate for cost of equity is obtained using a
simple estimation technique, in particular, in relation to the amount of data required for
estimation. If using CAPM, return on a market index and the return on the stock, over the
estimation period is the only data needed. While using Fama French, data for the additional two
factors are also required. This paper compares the performance of the CAPM with the Fama

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French model under the assumption that a simple estimation technique, in particular in relation to
the amount of data required, is used.
Author use R2 from a cross-section regression using individual 1 year stock returns as
the dependent variable and estimated factor(s) based on past returns as the explanatory
variable(s).
Author cite sufficient literature and mention that past study focused on reasons for differences in
estimated betas between periods and the ability of historical betas to predict future betas. He
listed Blume (1975), Carleton and Lakonishok (1985), Klemkosky and Martin (1975), and Reilly
and Wright (1988) as example.
Based on result of this paper, 5 years of monthly data appears to be appropriate,
concluded that the use of 5 years of monthly data and the CRSP equal-weighted index provides
the best estimate for beta, and therefore expected return, based on CAPM. Also the ability of beta
to explain differences in returns in subsequent periods ranges from a low of 0.01% to a high of
11.73% across years and is at best 3% on average are founded. It is of concern that so little of the
differences in returns between stocks are explained, under such favorable circumstances known
that the analysis was done for NYSE stocks that trade more than 95% of the time. The low
explanatory power of both the CAPM and the Fama French model suggests that neither model is
useful for estimation of cost of equity, at least for the simple estimation techniques used here.

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For the alternative, author suggested individual firms should use professional beta
providers for obtaining their beta estimates instead of estimating them themselves, and that
professional beta providers should use more complex techniques than used in his paper.
Author stressed that this issues cannot be taken for granted and point up for future research to
compare the betas from beta providers with those obtained using simple estimation techniques.

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References
Bartholdy, J., & Peare, P. (2005). Estimation of expected return: CAPM vs. Fama and French.
International Review of Financial Analysis, 14(2005), 407-427. doi:10.1016/j.irfa.2004.10.009
Roll, R. (1988). R2. Journal of Finance, 43(2), 541 566.
Blume, M. (1975). Betas and their regression tendencies. Journal of Finance, 30(3), 785 795.
Carleton, W., & Lakonishok, J. (1985, JanuaryFebruary). Risk and return on equity: The use
and misuse of historical estimates. Financial Analyst Journal, 41, 38 47.
Reilly, F., & Wright, D. (1988, Spring). A comparison of published betas. Journal of Portfolio
Management 6469.
Bruner, R. F., Eades, K., Harris, R., & Higgins, R. (1998). Best practices in estimating the cost of
capital: Survey and synthesis. Financial Practice and Education, 8(1), 13 28.

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