Question

r-squared values normally improve when using the Fama French three factor model to forecast the cost of equity.  What does the r-squared value represent and why don’t we simply use the Fama French model as opposed to CAPM for calculating the cost of equity

Answer 1

Answer:-

The r-squared value represents that the statistical measure of how close the given data is to the regression line. It represents the proportion of variance of the dependent variable that is explained by an independent variable in regression model. A regression value of 100% means that the model explains all the variability of the data around the mean.

The CAPM model is very simple to use as it uses only one factor beta which captures the systematic risk. The Fama french model which is a multi factor model though have high explanatory power but it's reliability is not assured as it uses many factors and there is high probability of errors in estimation of those factors. The Fama french model is more complex and expensive to use compared to the CAPM model. Therefore the CAPM model is mostly preferred for calculating the cost of equity.