The Five-Factor Asset Pricing Model: A Corporate Finance Point of View

Abstract

Derivations of the ‘Terminal Value of Free Cash Flow’-formula (Koller & Goedhart, 2015) show that the return on investment capital is a key driver of firm value. This implies that the investment factors from well-established asset pricing models might be mis-specified since they view the absolute level of investment undertaken as the only source of risk related to investments. This thesis suggests that there might be additional risk related to the return on the investments undertaken by firm’s, which is left un-captured by five-factor asset pricing models, e.g. the Fama French Five-Factor Model (Fama & French, 2015) and the Empirical Q-Factor Model (Hou, Xue and Zhang, 2015). Our results suggest that investors should receive additional compensation for value added or destroyed through a firm`s investment policy and not only according to absolute size of investment. However, the empirical performance of our models is poor, and our results are limited to test asset portfolios based on Size-B/M.