A Five-Factor Asset Pricing Model with Enhanced Factors

Abstract

A simple manipulation of the dividend discount model establishes that firms' book-to-market, profitability, and investment are related to their expected returns. This insight motivates the value, profitability, and investment factors in the Fama-French (2015) five-factor model. Yet, variation in book-to-market, profitability, or investment stems not only from differences in expected returns. In this study, we narrow down the variation in these variables that is actually informative about expected returns to construct enhanced versions of the value, profitability, and investment factors. Our enhanced factors exhibit considerably higher Sharpe ratios than the standard factors. Importantly, a five-factor model using our enhanced factors exhibits a much better pricing performance and generates a more upward sloping multivariate security market line than the standard five-factor model. Moreover, we show that our approach either complements or outperforms other recently proposed approaches to improve the Fama-French (2015) factors.

Keywords: Fama-French five-factor model, value factor, profitability factor, investment factor, cash flow shocks

JEL Classification: G12, G14