Analysis of Equity Risk Using Fundamentals Factor Models
Throughout this book, we have described various measures computed from financial statements and ratios that have combined financial statement data and market data. We discussed how these measures can be used to evaluate the economic prospects of a company. In Chapter 5, we began the process of showing how a company's stock can be valued using a discounted value approach and we presented several dividend discount models that are used by practitioners. In this chapter, we look at another approach to valuation, factor models. While there are different types of factor models, our focus in this chapter is on fundamental factor models, which use the various measures discussed in this book as inputs to the model.
Our objective is not to discuss how factor models are built. Rather, our objective is simply to demonstrate how various measures are used in models to estimate the expected return on stocks and to manage portfolios.
It is well known that there is a positive relationship between risk and expected return. That is, the greater the risk, the higher the expected return that investors want. This is a basic principle of financial theory. The tough part is figuring out the appropriate way to define risk and to how to quantify that risk.
The term “risk” is used very casually in the financial press and in day-to-day conversations about investments. Financial theory provides a more specific definition of ...