3-5 Estimating the Cost of Equity Using the Fama-French Method Telecom services is an industry under rapid transformation because telephone, Internet, and television services are being brought together under a common technology. In fall 2006, the telecom analyst for HML Capital, a private investment company, was trying to evaluate the cost of equity for two giants in the telecom industry: SBC Communications (AT&T) and Verizon Communications. Specifically, he wanted to look at two alternative methods for making the estimate: the CAPM and Fama-French three-factor model. The CAPM utilizes only one risk premium for the market as a whole, whereas the Fama-French model uses three (one for each of three factors). The factors are (1) a market risk premium, (2) a risk premium related to firm size, and (3) a market-to-book risk premium. Data for the risk premium sensitivities (b, s, and h) as well as the beta coefficient for the CAPM are listed in the following table: CAPM Risk free rate Market risk premium Beta Rf Rm - Rf Beta SBC 0.03 0.05 0.62 VZ 0.03 0.05 0.79 Cost of equity from CAPM ?? ?? Fama-French three factor model Fama-French risk premium Risk premium Market risk Firm-size Market-to-book pb = Rm - Rf ps ph 5.00% 3.36% 4.40% Coefficient b Market risk Firm-size Market-to-book SBC 0.030 1.060 - 1.500 VZ 0.030 1.111 -0.954 s h FF cost of equity ?? ?? 1. If the risk-free rate of interest is 3%, what is the estimated cost of equity for the two firms using the CAPM? 2. What is the estimated cost of equity capital for the two firms using the Fama- French three-factor model? Interpret the meaning of the signs. 19 Q3-5 20 21 a CAPM 22 VZ 23 Rf SBC 0.03 0.05 0.62 Risk free rate Market risk premium Beta 24 Rm - Rf Beta 0.03 0.05 0.79 25 26 27 a-1 Cost of equity from CAPM ?? ??