The Fama-French three-factor model predicts the risk-return relationship better than CAPM.
(Nobel Laureate Eugene Fama and researcher Kenneth French, former professors at the University of Chicago Booth School of Business).
The three-factor model is an improved version of CAPM. Before this model was developed, there was also the Arbitrage Pricing Theory (APT), which posits that returns depend on various macroeconomic factors and their betas, although the theory does not specify these factors.
The three-factor model essentially combines CAPM and APT. It was found that small companies perform better compared to large ones, and high Book-to-Market companies perform better compared to low Book-to-Market ones, so these two factors were added to CAPM.
[ r − rf = β1 \cdot \text{market} \cdot (r1) + β2 \cdot \text{size} \cdot (r2) + β3 \cdot \text{book-to-market} \cdot (r3) ]
where ( r1 ), ( r2 ), ( r3 ) are the corresponding factors.
It is interesting that we have specific figures based on statistical research:
From 1926 to 2014, the capitalization of small companies’ assets exceeded that of large companies by an average of 3.5% annually, while Value companies outperformed Growth companies by 4.8%.
Additionally, a study of 60 months of data (2009-2014) determined the sensitivity of these factors for 10 industries.
If you look at the table, you will see that the sensitivity parameters are negative in some industries, predicting lower profitability compared to CAPM. This means that although the factors are generally positive for the market on average, their variability negatively impacts certain industries…
You can find a video description of the model here:
Video Description of the Model.
Source:
Principles of Corporate Finance, 12th Edition
By Richard Brealey, Stewart Myers and Franklin Allen