A Dividend-Based Model to Explain the Cross Section of Equity Returns for Both Financial and Non-Financial Stocks

Abstract

Estimates of expected returns based upon the Fama-French and Carhart models typically exclude financial firms, including the latest FF five-factor model (Fama and French, 2015) or Gregory et al. (2013) for the UK. The presumed reason for this is that the book-price-based HML factor is not comparable between nonfinancial (predominantly historic-cost accounting) and financial firms (predominantly fair-value accounting). However, this approach excludes about 20% of FTSE 100 market capitalization. This paper proposes an alternative model of expected returns that can be applied to both sets of firms. To do this, we replace the HML factor with a dividend-yield-based factor which resolves the accounting issue present in the HML factor – thereby obviating the need to remove financial firms. We construct the factor based on dividend yield sorts in the same way as Fama-French calculate the HML factor based on book-price sorts. Empirically, we base our analyses on the UK market because a large proportion of firms there pay out dividends. We find that: i) replacing HML with PMR (payers-minus-retainers) produces equivalent results for nonfinancial firms; ii) the PMR factor is able to explain returns for portfolios of financial services stocks; iii) the model can be used to combine financial and nonfinancial firms in the same sample in analyses that require the calculation of expected returns.