Using Factor Models to Compute Costs of Equity Capital
Roy Verbeek∗
16 November, 2016
JOB MARKET PAPER
ABSTRACT
In this paper, I estimate costs of equity capital for individual firms and industries using five models:
(1) the CAPM, (2) the Fama and French (1993) three-factor model, (3) the Carhart (1997) fourfactor model, (4) the Fama and French (2015) five-factor model, and (5) the Hou, Xue, and Zhang
(2015a) four-factor model. I examine (i) model disagreement, (ii) estimation uncertainty, and
(iii) forecasting power for future returns. I find that the models differ greatly in their expected
return point estimates, but that the standard errors around these point estimates are so large that
these differences are often not statistically significant. All the models exhibit some forecasting
power for future returns, but only when standard errors are low. My results raise questions about
the applicability of popular asset pricing models. They further indicate a trade-off between the
improved in-sample pricing ability of models with more factors and the increased expected return
standard errors that such models yield.
∗
Rotterdam School of Management, Erasmus University, Burgemeester Oudlaan 50, 3062 PA Rotterdam, the
Netherlands. E-mail: [email protected]. I would like to thank Dion Bongaerts, Mathijs Cosemans, Pascal François,
Bruno Gérard, Rogier Hanselaar, Espen Henriksen, Xavier Mouchette (discussant), Laurens Swinkels, Marta Szymanowska, Mathijs van Dijk, Wolf Wagner, Darya Yuferova, and seminar participants at Erasmus University, Norwegian School of Management (BI), and the 33rd International Conference of the French Finance Association for their
helpful comments and suggestions. All errors are my own.