Module II· Cost of Equity & CAPMAdvanced

Question

What is the Fama-French three-factor model, and when is it relevant for IB valuations?

Answer

Mechanics

Fama-French extends CAPM with two factors: SMB (Small Minus Big — the size effect) and HML (High Minus Low — the value effect, B/M ratio). CoE = Rf + β_M × ERP + β_SMB × SMB + β_HML × HML. Empirically it explains 90%+ of cross-sectional returns vs. ~70% for CAPM. The five-factor model adds profitability (RMW) and investment (CMA). Rarely used directly in IB — but the model explains why the Ibbotson size premium is consistently positive (it compensates the SMB factor).

Deep diveShow more details

Pitch tip

'The size premium in the CAPM build-up is essentially the SMB factor from Fama-French — we build it in implicitly via Duff & Phelps data.'

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