Introduction
The Capital Asset Pricing Model (CAPM) is a widespread approach explaining stock price returns. However, Eugene Fama and Kenneth R. French conducted their study to reveal that this model was ineffective and lacked precision. The researchers indicated that the CAPM did not draw adequate attention to all the necessary factors and metrics, which did not allow it to explain and predict asset pricing. That is why Fama and French developed their model, which preferred value versus growth stocks. They focused on four factors to explain stock returns, considered multiple risk measures, and offered specific implications for investors.
Defining Value vs. Growth Stocks
Fama and French researched to deny the conventional wisdom that growth stocks are more profitable than value stocks. It is reasonable to start by presenting the definitions of these two terms. The scholars differentiate between the two since they mention that growth stocks represent good companies with high returns.
In contrast, value stocks feature low prices that emerge because these companies are traded below their actual value. The distinction between the two stocks is based on their book-to-market values. According to Fama and French, high book value ratios to market value are typical for value stocks, while low ratios characterize growth stocks. The CAPM is based on the conventional wisdom that growth stocks outperform value stocks in profitability.
Analysis of the relevant literature demonstrates that the two researchers’ definitions are not unique in the scientific field. On the one hand, Gagliolo and Cardullo (2020, p. 7) define value stocks as “securities traded on the market at a lower price than the issuing company’s intrinsic value.” Vasconcelos and Martins (2019, p. 293) rely on the same strategy as Fama and French and stipulate that high book-to-market indicators are typical for value stocks.
On the other hand, growth stocks relate to extensive and effective companies that are active in innovation and, therefore, can outperform the market over time (Gaglioloand Cardullo, 2020, p. 7). According to Vasconcelos and Martins (2019, p. 293), low book value ratios to market value characterize growth stocks. Thus, various authors offer the exact definitions of the phenomena under analysis, which contributes to the consistency of terminology used in the study by Fama and French.
As mentioned above, the two scholars wanted to refute the conventional wisdom that growth stocks could outperform value ones. Fama and French found that their theory worked well in 12 of 13 developed countries, including the United States of America. The selected scholarly articles offer additional insight into the topic. Gagliolo and Cardullo (2020, p. 7) focused on the Italian environment. They found controversial results because they determined that value stocks were only more profitable during the economic period before the 2008 crisis.
The study in Brazil, a developing nation, generated the opposite outcomes. Vasconcelos and Martins (2019, p. 293) mention that growth firms obtained significantly higher revenues than value stocks. This finding was aligned with the efficient market hypothesis, stating that growth stocks were less risky and could grow faster (Vasconcelos and Martins, 2019, p. 294). Consequently, the two phenomena are essentially different, and their profitability depends on the market. Fama and French explain that value stocks are more profitable in developed economies, and the following information offers additional arguments in favor of this statement.
Factors Explaining Stock Returns
In their study, the researchers determined that being a growth or value company is not the only criterion determining the presence and amount of stock returns. Fama and French indicate that average returns depend on four factors, including the price-earnings ratio, firm size, book-to-market equity, and leverage. The following paragraphs will present detailed descriptions to explain the connection between the four variables and stock returns.
Price-Earnings Ratio
First, one should explain what the price-earnings (P/E) ratio is. This metric helps investors see and analyze the correlation between a company’s stock and earnings that it generates (Berger and Curry, 2023, para. 1). It is calculated by dividing the stock price per share by the business’s earnings per share. The P/E ratio can be high and low, where the high ratio refers to growth stocks, while the low ratio characterizes value stocks.
It is possible to use this metric and information to predict stock returns in the future. According to the definition above, Amazon is a growth stock because its P/E ratio is 123. In contrast, the P/E ratio of 9 makes Citigroup a value stock (Berger and Curry, 2023, para. 18). This information demonstrates that investing in Citigroup can be beneficial because it will take less time to receive earnings to cover the cost of the initial investment.
Company Size
Second, a firm size is a broad metric because it can be measured in multiple ways. For example, investors can rely on market capitalization, total assets, total sales, and other financial indicators to decide whether a company is a small or large cap. This distinction is important because it can predict potential stock returns in the future. The rationale behind this statement is that smaller firms have more opportunities and abilities to obtain higher average returns (Astakhov, Havranek, and Novak, 2019, p. 1463).
It occurs because large companies have already achieved some success, which makes it challenging for them to find new drivers of growth and development. In addition, small caps are characterized by limited resources and more significant challenges, making them willing to accept increased risk. Investors should consider this information when they decide to chase higher returns.
Book-to-Market Equity
Third, the book-to-market (B/M) equity is another helpful metric for consideration. It focuses on the correlation between a company’s book value (assets minus liabilities) and its market value (number of shares outstanding multiplied by a single share price). Thus, if a book value is lower than a market value, the business is overvalued, while the opposite scenario indicates undervalued companies that are attractive to investors.
In addition, empirical evidence demonstrates that this metric cannot predict stock returns. Ball et al. (2020, p. 232) stipulate that the B/M equity “predicts stock returns only because it contains retained earnings.” In other words, this information is valuable because it reveals how much money the business can return to its investors.
Leverage
Fourth, leverage is the last factor that Fama and French analyzed. This term refers to how a company uses debt and borrowed funds in their business operations. The general wisdom is that such financing can have controversial impacts on a company. When a business experiences a growth period, the leverage can amplify returns. However, a crisis can lead to more significant losses because the company should pay its debts irrespective of whether it succeeds or fails.
Simultaneously, Claassen, Dam, and Heijnen (2023, p. 14) rely on a stochastic Ramsey model to demonstrate a clear connection between low leverage and high expected returns. These scholars additionally mention that it is reasonable to adjust for leverage to improve the CAPM effectiveness because this action reveals returns without the effect of borrowed funds (Claassen, Dam, and Heijnen, 2023, p. 3). That is why investors should draw attention to the size of debt to make informed decisions.
The discussion above demonstrates that the selected factors can help predict stock returns. In their study, Fama and French stipulate that the company size and B/M equity bring variations that deny all the predictions explained by the other factors. This statement denotes that no variable should be used in isolation. Furthermore, the two researchers added that the CAPM was ineffective because it only focused on a single measure of risk, i.e., the sensitivity to the market return.
Three Measures of Risk
Since Fama and French demonstrate that the CAPM does not work because it relies on a single risk, the experts offer two additional measures to consider. In particular, they state that it is necessary to distinguish the risks in small stocks versus big stocks and the risks in value stocks versus growth stocks. Thus, all three risk measures should be analyzed to arrive at valuable investment conclusions.
Beta (Volatility of Returns)
The first measure of risk refers to the sensitivity to the market return. This aspect is known as beta in the CAPM and discloses valuable information. According to Rutkowska-Ziarkoet al. (2022, p. 2), this issue stipulates that a given company’s price significantly depends on its market portfolio’s total price. This statement denotes that market movements, either upside or downside, can essentially and directly impact stock price. That is why the beta value can be divided into three meaningful groups.
When a company has a beta of 1, its stock price is expected to mimic the market movements. A beta of below 1 denotes lower volatility, while everything above 1 denotes that the stock features increased volatility compared to the market. For example, if a company has a beta of 1.15, its potential returns will be 15% more volatile than the market average. That is why such businesses offer better investment returns during market upturns and bring more significant losses during downturns.
Stock Size
However, the impact of market fluctuations is not the only risk that deserves attention. The second issue relates to the risk between small and big stocks. The scholarly article by Handayani, Farlian, and Ardian (2019, p. 171) indicates that a company’s size notably impacts its returns. Thus, larger firms are more trusted and have better capital access, making them more profitable for investors (Handayani, Farlianand Ardian, 2019, p. 179).
The scholars conducted multiple statistics tests to arrive at this conclusion and stipulate that the combination of the two above risks can help predict stock returns more effectively (Handayani, Farlian, and Ardian, 2019, p. 180). Even though this study is limited to the Indonesian context, it generates valuable information for investors. Experts should understand that the sensitivity to the market return is not the only aspect worth consideration.
Value vs. Growth Stocks
The third measure of risk that deserves attention refers to the risk associated with value versus growth stocks. It has been discussed above that these two types of stocks are significantly different and imply various returns. That is why investors should understand the risks of dealing with the two stocks. Low P/E ratios are typical for value stocks, which can lead to stable cash flows and lower growth potential (Berger and Curry, 2023, para. 1).
In turn, growth stocks feature low P/E ratios, which denotes that increased risk and higher potential returns are characteristic features. This issue is also known as a style risk because it relates to investors’ preferences in their work. It is possible to rely on Fama and French models to control this risk because the two researchers stipulate that value stocks are generally more profitable than growth stocks (Li and Duan, 2021, p. 2). Experts should keep this information in mind to make correct decisions.
One should specify that a better option is to consider all three risks because they focus on different vital aspects of a company and the entire industry. For example, Li and Duan (2021, p. 2) mention that a growth stock with a small market capitalization can outperform the entire market. That is why the CAPM model should be enriched with additional risk measures to guarantee that greater returns can be achieved. This approach will demonstrate that investors can analyze multiple aspects and their impact on potential benefits.
Implications
The information above presents and discusses two distinct models, the CAPM being the first. Fama and French decided to analyze the effectiveness of the strategy that used to be a working explanation of the relationship between risk in stocks and expected return. In particular, Giradin (2023, para. 2) adds that the selected approach tries to predict stock returns according to the inherent risks of the market. This statement relates to the sensitivity to the market return incorporated into the CAPM. Even though the model was widespread in the late 20th century, a closer analysis revealed its inefficiencies.
A simplistic view of the world is the most significant drawback of this approach. It is simultaneously the first implication for investors who should understand that predicting stock returns is challenging and complex. It is unreasonable to rely on the CAPM alone and expect it to generate positive outcomes. In addition to that, one should acknowledge that the selected model is limited because it only uses historical data since past stock prices are analyzed to determine investment risk (Giradin, 2023, para. 25). That is why using the CAPM to make investment decisions is not sufficient and reasonable.
That discovery made Fama and French upgrade the CAPM to ensure that it is possible to predict potential stock returns. On the one hand, the scholars highlighted the impact of four variables, including P/E ratios, firm size, B/M equity, and leverage. Specific research activities revealed that each could explain and predict variations in average returns.
On the other hand, Fama and French made the CAPM broader in terms of inherent risk. In addition to the sensitivity to the market return, the two experts commented on the size and style risks. Attention to these issues is needed to arrive at a suitable investment decision. Thus, the second implication for investors relies on the fact that they should analyze multiple variables and measures of risk to make more precise predictions of stock returns.
The third implication provides investors with specific advice on how to earn money from investment. Fama and French determined that value stocks, on average, were more profitable than growth stocks in developed states. In particular, high B/M indicators explained this result because they denoted that value stock was undervalued in the market. The findings by Fama and French are aligned with the current scientific literature.
For example, Gagliolo and Cardullo (2020, p. 7) mention that value stocks were significantly profitable in Italy before the 2008 financial crisis. Vasconcelos and Martins (2019, p. 293) proved this hypothesis from the opposite direction because they found that growth firms generated higher revenues in Brazil, i.e., a developing nation. That is why investors can benefit from this implication and prefer investing in value stocks to increase the probability of obtaining more significant returns.
Conclusion
This continuous assessment focused on the CAPM and analyzed Fama and French’s research, which proved its inefficiency. The researchers determined that the model should have drawn attention to four variables, P/E ratios, firm size, B/M equity, and leverage, and considered three risk measures to arrive at practical conclusions and recommendations. It is challenging to overestimate the work by Fama and French since the two identified essential drawbacks within the approach that used to be a leading guideline for financial experts in the late 20th century. That is why real professionals can benefit from the article by Fama and French, as it provides them with practical advice on how to succeed in the stock market.
Reference List
Astakhov, A., Havranek, T. and Novak, J. (2019). ‘Firm size and stock returns: a quantitative survey’, Journal of Economic Surveys, 33(5), pp. 1463-1492.
Ball, R. et al. (2020) ‘Earnings, retained earnings, and book-to-market in the cross section of expected returns’, Journal of Financial Economics, 135(1), pp. 231-254.
Berger, R. and Curry, B. (2023) How to understand the P/E ratio. Web.
Claassen, B., Dam, L. and Heijnen, P. (2023) ‘Corporate financing policies, financial leverage, and stock returns’, The North American Journal of Economics and Finance, 68, pp. 1-18.
Gagliolo, F. and Cardullo, G. (2020) ‘Value stocks and growth stocks: a study of the Italian market’, International Journal of Economics and Financial Issues, 10(3), pp. 7-15.
Giradin, M. (2023) What is CAPM (the capital asset pricing model)? Web.
Handayani, M., Farlian, T. and Ardian, A. (2019) ‘Firm size, market risk, and stock return: evidence from Indonesian blue chip companies’, Jurnal Dinamika Akuntansi dan Bisnis, 6(2), pp. 171-182.
Li, K. and Duan, Y. (2021) ‘Research on the application of Famaand French three-factor and five-factor models in American industry’, Journal of Physics: Conference Series, 1865(4), pp. 1-5.
Rutkowska-Ziarko, A. et al. (2022) ‘Conventional and downside CAPM: the case of London stock exchange’, Global Finance Journal, 54, pp. 1-13.
Vasconcelos, L.N.C.D. and Martins, O.S. (2019) ‘Value and growth stocks and shareholder value creation in Brazil’, Revistade Gestão, 26(3), pp. 293-312.
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