Businesses and companies follow various accounting standards to prepare and present their financial statements. These standards regulate how companies account for transactions. Some countries may have their specific standards. However, most of these companies use variations of international standards already developed by standardized bodies. When it comes to international accounting standards, there are two types of commonly used variations. The first one is the International Financial Reporting Standards (IFRS), which many countries and jurisdictions use. Some jurisdictions may customize some parts of those standards. On the other hand, the second one is Generally Accepted Accounting Principles (GAAP). This variation is only applicable in the US. What are the International Financial Reporting Standards?International Financial Reporting Standards (IFRS) represent a set of common rules applicable to accounting. These rules apply to any entity that prepares financial statements in jurisdictions where the IFRS is relevant. IFRS allows for a consistent, comparable, and transparent presentation of financial statements around the world. There are various standards with the IFRS that relate to particular areas of accounting within a company. For example, there are specific standards for Property, Plant & Equipment, Intangible Assets, and Inventory. These all apply to different areas for businesses and other entities. The goal of these standards is to standardize the reporting process. The International Financial Reporting Standards were previously known as International Accounting Standards (IAS). However, the IFRS got its name from the change in the body responsible for developing these standards. Who is responsible for developing and maintaining the International Financial Reporting Standards?The International Financial Reporting Standards (IFRS) come from the International Accounting Standards Board. It is an independent, private-sector body responsible for developing and maintaining the standards within the IFRS. The IASB was the successor of the International Accounting Standards Committee in 2001. The International Accounting Standards Foundation also changed its name to the International Financial Reporting Standards Foundation (IFRS Foundation). Any standards developed during the previous foundation’s period come with the IAS tag. For example, the IAS 16 is the standard for Property, Plant, and Equipment, which is still applicable. How do the International Financial Reporting Standards (IFRS) differ from the Generally Accepted Accounting Principles (GAAP)?As mentioned, IFRS is applicable in several countries in the world. According to the latest count, 120 countries use the IFRS. On the other hand, the Generally Accepted Accounting Principles are only applicable in the US. However, that is not the only difference between these two. They also differ from each other in one other major aspect. The IFRS takes a principle-based approach towards standardizing accounting. It may require more judgment and interpretation. However, it allows entities much better flexibility with the usage. On the other hand, GAAP uses a rules-based approach to accounting. This approach provides industry-specific rules and guidelines for each entity. However, it does not provide the same level of flexibility as the IFRS. Apart from that, the IFRS and GAAP also vary from each other in specific accounting areas. For example, IFRS only allows the FIFO and weighted-average cost method of valuing inventory. GAAP, on the other hand, also allows the LIFO method. Similarly, there are various other areas where they may differ from each other as well. ConclusionThe International Financial Reporting Standards is a set of common rules that aim to bring consistency, comparability, and transparency to financial reports. IFRS comes from the International Accounting Standards Board. These standards are prevalent in 120 countries worldwide. IFRS is different from the Generally Accepted Accounting Principles, which is applicable in the US. Post Source Here: International Financial Reporting Standards
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What is Enterprise Value to Sales Ratio?Enterprise Value to Sales Ratio (EV/Sales) is a financial metric that investors use to measure a company’s total value in relation to its sales. The first part of the ratio is the Enterprise Value. A company’s enterprise value is the sum of its current market cap, debt, minority interest, preferred shares after deducting its cash balances. Enterprise value to sales ratio is a crucial metric that investors use to calculate a stock's market value. Using this ratio, investors can determine whether a company's stock in the market is undervalued or overvalued. Usually, a higher EV/Sales ratio represents an expensive or valuable stock. Another name for the ratio is the Enterprise Value to Revenue ratio or multiple. How to Calculate the Enterprise Value to Sales Ratio?Calculating the EV/Sales ratio is straightforward. As the name suggests, it is the ratio of a company’s enterprise value and its sales. Therefore, the formula will be as follows. Enterprise Value to Sales Ratio = Enterprise Value / Net Sales A company’s net sales are available in its Income Statement. However, investors need to calculate the Enterprise Value manually. They may need to obtain the information for this calculation from external and internal sources. The formula to calculate Enterprise Value is as below. Enterprise Value = Market Capitalization + Debt + Preferred Shares + Minority Interest - Cash and Cash Equivalent Balances Most of the information available for the above formula is available in a company's Balance Sheet. However, the market capitalization may need some external research. ExampleA company, Green Co., has a total market capitalization of $100 million. The company reports total debt of $20 million and preferred shares of $15 million in its balance sheet. Green Co. also has cash and cash equivalent balances of $25 million. The company made total sales of $50 million. Before determining Green Co.'s EV/Sales ratio, it is crucial to calculate its Enterprise Value. The calculation for Green Co.’s Enterprise Value will be as follows. Enterprise Value = Market Capitalization + Debt + Preferred Shares + Minority Interest - Cash and Cash Equivalent Balances Enterprise Value = $100 million + $20 million + $15 million - $25 million Enterprise Value = $110 million Therefore, Green Co.’s Enterprise Value to Sales Ratio will be as follows. Enterprise Value to Sales Ratio = Enterprise Value / Net Sales Enterprise Value to Sales Ratio = $110 million / $50 million Enterprise Value to Sales Ratio = 2.2 How does the Enterprise Value to Sales Ratio work?The EV/Sales ratio allows investors to evaluate a company's stocks. It is similar to the price-to-sales ratio (P/S). However, it uses a company's enterprise value instead. The EV/Sales ratio may range between 1 and 3. Investors usually prefer to invest in companies with a low EV/Sales ratio as it may indicate undervalued stocks. However, that may not always be true. Sometimes, a high EV/Sales ratio can also mean the companies have a high potential to grow their sales. Similarly, a low EV/Sales ratio may indicate a company has experienced a sudden or one-off increase in its revenues. This ratio provides better results if used comparatively with a company's past performances or the industry as a whole. ConclusionThe Enterprise Value to Sales Ratio considers the ratio between a company’s Enterprise Value and its Revenues. This financial metric is crucial for investors that want to identify undervalued or overvalued stock in a company. Usually, investors prefer investing in low EV/Sales ratio companies. However, there may be some exceptions to that rule. Originally Published Here: Enterprise Value to Sales Ratio What is Free Cash Flow to Equity?Free Cash Flow to Equity (FCFE) represents the cash available to a company’s shareholders or investors. These are the cash flows that come after deducting all the expenses, reinvestment, and debt expenses from a company’s total cash inflows. FCFE is a crucial metric for investors as it allows them to understand how much income they can get from their investments. Free cash flow to equity shows the cash that companies generate and are available for distribution to shareholders. However, that does not imply that the company must distribute it. There are some factors that may affect how much shareholders can receive. Despite that, FCFE allows shareholders to develop expectations. Similarly, it provides them with a comparison tool to use for various investments. How does Free Cash Flow to Equity work?The FCFE is a metric that investors use to measure a company’s value. Usually, investors can use the FCFE as an alternative method to evaluate a company that does not pay dividends. It is also better to use the FCFE for companies that have a stable capital structure. Sometimes, the FCFE calculation may also result in a negative amount. Investors usually prefer investing in companies with a positive or growing FCFE. It is because a negative FCFE can be an indicator of underperforming stocks. However, some stable companies may also have a negative FCFE due to large capital investments or debt repayments. How to calculate Free Cash Flow to Equity?The formula for Free Cash Flow to Equity is similar to that of free cash flow. However, it also considers the net debt issued by a company, which the original does not. Therefore, investors can use the formula below to calculate FCFE. Free Cash Flow to Equity = Cash from Operations - Capital Expenditure + Net Debt Issued All of the information required to calculate a company’s FCFE is available on its Cash Flow Statement. Sometimes, however, the information for the above formula may not be available. Therefore, investors may also use another formula to calculate FCFE, as below. Free Cash Flow to Equity = Net Income + Non-Cash Expenses ± Changes in Working Capital - Capital Expenditure + Net Debt Issued The above formula expands on the original one in calculating FCFE. The net income and non-cash expenses part of this formula are available in a company's Income Statement. The changes in working capital represent the differences between a company's opening and closing working capital balances. These include inventory, account payable, and account receivable balances. These are all available on the Balance Sheet. ExampleA company, Red Co., has a total net income of $500,000. The non-cash expenses, including depreciation and amortization, for Red Co., amount to $50,000. The net changes in working capital from the balance sheet were -$100,000. The company also incurred a capital expenditure of $150,000 during the period. Lastly, Red Co. also had net debt issued of $75,000. Therefore, Red Co.’s free cash flow to equity will be as below. Free Cash Flow to Equity = Net Income + Non-Cash Expenses ± Changes in Working Capital - Capital Expenditure + Net Debt Issued Free Cash Flow to Equity = $500,000 + $50,000 - $100,000 - $150,000 + $75,000 Free Cash Flow to Equity = $375,000 ConclusionFree cash flow to equity represents the cash available to a company’s investors. It is after deducting all expenses, reinvestment, and debt repayments from its cash inflows. FCFE is crucial for investors that want to measure a company's value. The calculation of FCFE is straightforward and similar to the FCF. Article Source Here: Free Cash Flow to Equity What is Free Cash Flow?Free Cash Flow (FCF) represents any cash that a company or business has left after paying for its operational needs and maintaining capital assets. Operating expenses include items, such as rent, salaries, and wages, taxes, etc., that companies pay to continue their activities. Similarly, capital expenditure consists of any costs borne on acquiring, maintaining, or upgrading assets. FCF is an alternative for other common types of performance indicators, such as net income. Instead of focusing on all expenses, free cash flow measures a company's profitability, excluding non-cash expenses. However, it includes relevant items, including capital expenditure and working capital changes. This way, FCF provides detailed insights into a company's cash management procedure. How do Free Cash Flows work?For most companies, a positive free cash flow indicates better financial health. A high free cash flow means that companies have enough cash to meet their obligations each month. On the other hand, a low or decreasing free cash flow can indicate financial problems. Investors also prefer to invest in companies that have positive or increasing free cash flows. However, decreasing free cash flows may not always indicate failures. Some one-off transactions can result in sudden dips in free cash flows. For relatively new businesses, free cash flows have significant variance compared to steady companies. Similarly, the industry in which a company operates also defines the norm for free cash flows. How to use Free Cash Flows in Investment Decisions?Just like normal cash flows, investors can use free cash flows in investment decisions. In fact, free cash flows are one of the prevalent methods in company valuation. With the FCF method of company valuation, a company's intrinsic value will be equal to the present value of its operating free cash flows. The formula for operating free cash flows is as follows. Operating Free Cash Flows = Earnings Before Interest and Tax x (1 - Tax Rate) + Depreciation - Capital Expenditure - Changes in Working Capital - Changes in Other Assets Once investors determine a company’s operating free cash flows, they can discount it using the Weighted Average Cost of Capital. This way, they can find the underlying company’s value. Therefore, the formula will be as below. Company Value = Operating Free Cash Flows / (1 + WACC) Investors can also factor in the expected growth rate for the company in that formula. This way, they can calculate the value of companies that they expect to have constant growth in operating free cash flows. The formula will be as follows. Company Value = Operating Free Cash Flows / (WACC - Expected Growth Rate of OFCF) For this variation, investors will need to calculate the expected growth rate. They can do so by calculating the product of a company's average retention rate and its return on invested capital. Once they do so, they can calculate a company's value and use it for further decision-making. ConclusionFree cash flow refers to cash that a company has left after accounting for operational needs and maintaining capital assets. Free cash flows can have many uses, one of which is for investment decisions. Investors can calculate a company's operational free cash flows and discount them at the Weighted Average Cost of Capital to determine its value. Article Source Here: Free Cash Flow Valuation Model What is Free Cash Flow to the Firm?Free Cash Flow to the Firm (FCFF) represents any cash remaining after deducting a company's depreciation, taxes, working capital, and other investment costs from its revenues. This amount shows any cash flow available for companies to distribute to their financiers, whether debtholders, stockholders, preferred stockholders, or bondholders. Free Cash Flow to the Firm also represents any surplus cash flows available to companies assuming they were debt-free. Therefore, another name for the FCFF is unlevered free cash flow. FCFF can help investors gauge a company's profitability after deducting all expenses and reinvestments. For most companies, the FCFF may also be an indicator of financial health. How to calculate the Free Cash Flow to the Firm?There are several ways in which investors can calculate a company’s Free Cash Flow to the Firm. These are as below. Free Cash Flow to the Firm = [EBIT x (1 - Tax Rate)] + Non-Cash Expenses + Changes in Working Capital - Capital Expenditure The [EBIT x (1 - Tax Rate)] part is also known as a company's Net Operating Profits After Taxes (NOPAT). The non-cash expenses part usually includes depreciation. Similarly, changes in working capital represent any investments that a company has made in its working capital. Lastly, capital expenditure includes all long-term investments that companies make. Another formula that investors can use to calculate the Free Cash Flow to the Firm is as follows. Free Cash Flow to the Firm = Net Income + Non-Cash Expenses + [Interest x (1 - Tax Rate)] - Capital Expenditure - Changes in Working Capital This formula uses a company’s Net Income instead of the NOPAT. The rest of the formula is similar to the one before. The next approach to calculating the Free Cash Flow to the Firm is as below. Free Cash Flow to the Firm = Cash flow from operations + [Interest x (1 - Tax Rate)] - Capital expenditures Lastly, investors can also use the formula below to calculate the Free Cash Flow to the Firm. Free Cash Flow to the Firm = [EBITDA x (1 - Tax Rate)] + (Depreciation x Tax Rate) - Capital Expenditure - Changes in Working Capital EBITDA is a company’s Earnings Before Interest, Taxes, Depreciation, and Amortization. What is the importance of Free Cash Flow to the Firm?Free Cash Flow to the Firm is a metric that is important for several reasons. Firstly, it presents investors with an alternative to the Earnings Per Share, which uses profits. These profits are easily manipulatable, making it difficult for investors to trust them. FCFF is also crucial for dividend-seeking investors. It is because it is a reliable measure of a company's ability to maintain dividend payments. Free Cash Flow to the Firm is also a great indicator of a company’s cash flow position. Companies that have consistently high FCFFs are likely to have a better cash management process. Similarly, FCFF is also useful for identifying growth-oriented stocks. High FCCFs mean that companies are likely to use their free cash for further investments. These can result in higher profits in the future. ConclusionFree Cash Flow to the Firm is a metric that investors can use to calculate a company's free cash flows. These come after deducting the company's depreciation, taxes, working capital, and other investment costs. Investors can use various formulas to calculate the FCFF. Post Source Here: Free Cash Flow to the Firm (FCFF) Most economies experience inflation regularly. Inflation represents a specific currency's purchasing power. A high increase in inflation can result in damage to most economies. Some economies may also experience negative inflation, also known as deflation. While, theoretically, it can be a good thing, it also has some drawbacks. What is Deflation?Deflation is an increase in the currency's purchasing power. Or it refers to the decline in the prices of goods and services. There are several reasons why deflation may occur in an economy. Usually, it relates to supply and demand. When the money or credit supply in an economy decreases, or productivity and the number of goods and services increases, it results in deflation. How does Deflation work?Same as inflation, the Consumer Price Index helps calculate the deflation in an economy. However, there are some factors that the index ignores, which can have an impact on it. Therefore, the index may not be a true indicator of inflation or deflation in an economy. When the index in one period for an economy is lower than the previous, inflation is said to have occurred. Deflation usually comes with a negative signal for an economy. It results in a decrease in the money supply in a country due to lower wages, hurts investment portfolios, and even causes unemployment. Therefore, deflation may also accompany a recession in the future. As the deflation in a country increases, the chances of a recession occurring in the future also increase. However, that does not mean deflation can only result in adverse effects. Deflation can also result in increased nominal consumer spending. Since deflation causes an increase in purchasing power of a currency, it means more people can afford items. With the increased spending by consumers, deflation can positively stimulate the economy. Why is Deflation bad?Despite its positive effects, deflation is usually bad for the economy. Although deflation can stimulate the economy with increased consumer spending, there is no guarantee that will happen. As the prices of goods and services start declining, consumers will postpone their spending. Usually, this is because they hope the prices will decrease even further in the future. Therefore, deflation slows a country's economic growth. Due to the decreased spending by customers, manufacturers are forced to reduce their prices. For most consumers, it provides a choice between various products at affordable prices. However, it causes manufacturers to employ cost-cutting measures. Some manufacturers may also suffer significantly and go out of business. Either way, deflation can cause unemployment in an economy aside from its other adverse impacts. Similarly, it decreases a country’s GDP, which can even further magnify the problem. Apart from manufacturers and consumers, deflation can also affect borrowers. They have to repay lenders a higher amount due to the increase in the currency’s purchasing power. Overall, deflation can cause a chain of events that can lead to a severe economic decline. Long periods of continuous deflation can even force economies to go into recession. ConclusionDeflation refers to the increase of a currency's purchasing power. While deflation can have a good effect on an economy, in some cases, it can also impact a country adversely. Deflation can cause a decline in consumer spending as they postpone it, hoping to get lower prices in the future. It can result in lower earnings for manufacturers and can further result in other problems. Originally Published Here: Why Deflation Is Bad? There are several ratios that investors may use to gauge a company's profitability and performance. Some of these may focus on the company's profitability only. However, some others also help investors measure the company's performance and efficiency. Among those, one of the most prominent ratios is the Return on Capital Employed (ROCE). What is Return on Capital Employed?Return on Capital Employed is a profitability and performance ratio that allows investors to assess a company’s profitability. It does so by gauging its efficiency in managing its capital. While investors want to know how profitable a company is, it is also crucial to determine how much capital it has used. It allows investors to make better comparisons between companies of different sizes. ROCE is one of the most favourite ratios for investors. It combines several elements related to a company's profitability into one. Simply put, it is the ratio of a company's earnings and its capital employed. Overall, ROCE provides investors with a reliable and better measure of corporate performance. It is also easy to calculate as the information needed to use the ROCE formula is available in the financial statements. How to calculate Return on Capital Employed?Investors can use the following ratio to calculate a company’s Return on Capital Employed. Return on Capital Employed = Earnings Before Interest and Tax (EBIT) / Capital Employed The Earnings Before Interest and Tax is available in a company's Income Statement. On the other hand, the capital employed is available in the company's Balance Sheet. There are two ways to calculate capital employed. Capital Employed = Total Assets - Current Liabilities Similarly, they can also use the following formula. Capital Employed = Total Equity + Non-Current Liabilities Regardless of which method investors use, investors will get the same capital employed. ExampleA company, Blue Co., had Earnings Before Interest and Tax (EBIT) of $100,000 in the last accounting period. The company also has total assets of $1 million and current liabilities of $200,000. Therefore, Blue Co.'s capital employed is $800,000 ($1 million - $200,000). It allows Blue Co. to calculate its Return on Capital Employed as follows. Return on Capital Employed = Earnings Before Interest and Tax (EBIT) / Capital Employed Return on Capital Employed = $100,000 / $800,000 Return on Capital Employed = 0.125 or 12.5% How does the Return on Capital Employed work?Return on Capital Employed is a metric that allows investors to compare various companies. Usually, a higher ROCE means that the company has efficiently used its resources to generate profits. ROCE is also useful in comparing companies in capital-intensive industries, allowing investors to make better decisions. Return on Capital Employed shows how much earnings a company makes for each dollar of capital employed. It considers the EBIT, which shows how much profits a company generates from its operations only. Similarly, by incorporating equity and long-term debt, ROCE allows investors to consider the long-term capital which a company employs. ConclusionReturn on Capital Employed is one of the most preferred ratios for investors. It allows them to gauge a company's profitability and efficiency in using its resources. In short, Return on Capital Employed is the ratio of a company's EBIT and its capital employed. The higher a company's ROCE is, the better it is for investors. Article Source Here: Return on Capital Employed Investors can use various profitability ratios to evaluate whether they should invest in a company. Some of these ratios are basic and allow investors to determine whether the company is profitable. However, investors may also want to know the returns they will get on their invested amounts. For these calculations, investors may use the Return on Invested Capital (ROIC). What is Return on Invested Capital?Return on Invested Capital is a profitability ratio that represents the percentage return that companies earn from their invested capital. ROIC is a metric that allows investors to determine how efficiently a company allocates its resources to make profits. Investors can use ROIC to gauge how much they can earn for the amount of investment they make in the company. How to calculate Return on Invested Capital?Investors can use the following formula to calculate the Return on Invested Capital for a particular investment. Return on Invested Capital (ROIC) = Net Operating Profit After Tax (NOPAT) / Invested Capital For the above formula, investors must first determine how much return the company generates. It includes after-tax earnings but before interest payments. This amount is not available in the company's financial statements. Therefore, investors will have to calculate it manually. The formula for NOPAT is as below. NOPAT = Earnings Before Interest and Taxes (EBIT) x (1 - Tax Rate) Most of the information for the above formula is available in a company's Income Statement. Therefore, calculating NOPAT should be straightforward. Next, they must determine the value of the invested capital. Invested capital represents the amount that investors have contributed to the company through the purchase of shares. There are various ways to calculate the invested capital for a company. Firstly, there is the following formula. Invested Capital = Total Debt + Total Equity and Equivalent Equity Investments + Non-Operating Cash However, investors may also use the following formula to calculate the invested capital. Invested Capital = Net Working Capital + Net Fixed Assets + Net Intangible Assets ExampleA company, Green Co, has Earnings Before Interest and Tax of $100,000. Similarly, the tax rate prevalent for the company is 20%. The total invested capital of Green Co. is $400,000. Therefore, Green Co.'s Return on Invested Capital will be as follows. Return on Invested Capital = Net Operating Profit After Tax (NOPAT) / Invested Capital Return on Invested Capital = [$100,000 x (1 - 20%)] / $400,000 Return on Invested Capital = 0.2 or 20% How does Return on Invested Capital work?The Return on Invested Capital formula returns a percentage value. It provides a measure of a company’s performance, showing much return it generates for each dollar of invested capital. Unlike some other ratios, investors can use ROIC both on its own and comparatively. They may also use as a comparative tool with a company’s weighted average cost of capital. Usually, the higher a company's ROIC is, the more profitable and efficient it is. Similarly, companies with ROIC higher than their WACC maximize returns for the invested capital. Investors also prefer to invest in companies that have an ROIC of at least 2% or higher. Anything below that usually indicates an inefficient use of resources. ConclusionReturn on Invested Capital is a measure of efficiency and profitability for companies. Investors use it to determine whether they should invest in a company or not. The ROIC formula requires investors to take the ratio between a company's returns and its invested capital. Investors can use ROIC on its own or comparatively. They can also use it to compare a company's ROIC with its WACC. Post Source Here: Return on Invested Capital Inflation refers to the decrease in a currency's purchasing power. It can come as a result of various factors. Inflation isn't necessarily a bad thing, as it can also accompany positive changes. However, it usually has adverse effects on businesses and individuals. Inflation risk, also known as purchasing power risk, exists for all companies that suffer from inflation. What is Inflation Risk?Inflation risk refers to the uncertainties or hazards involving inflation. For companies, it refers to the risk that inflation may occur and accompany adverse impacts. Inflation risk represents how changes in prices of goods and services can affect a company's operations negatively. Similarly, it may refer to the decrease in purchasing power more than expected by a company. Inflation risk also exists for investors. In that context, it refers to the risk that inflation will undermine an investment's performance. Usually, investors want to get returns above the inflation rate that occurs. Therefore, they take inflation into account when making decisions about their portfolios. If the cash flows from an investment are lower than the inflation rate, then investors have to suffer. How does Inflation Risk work?When investors invest in security, they will expect a specific amount of return. For example, when investing in bonds, investors can expect a fixed-income. These investments may be short- or long-term. While inflation risk may exist for short-term investments, it does not have a significant impact. For long-term investments, inflation risk may have a substantial effect. Investors that invest in long-term securities want the returns from them to exceed the inflation rate. For fixed-rate returns, inflation rates will have a significant impact on the returns. However, the same is not the case for securities that account for inflation, for example, inflation-rate or floating-rate bonds. In these cases, the inflation risk will be minimal or at least lower than for fixed-rate securities. Why is Inflation Risk crucial?Inflation risk is crucial for investors as it dictates the returns they receive and expect. As mentioned, inflation risk has more impact on long-term investments compared to short-term ones. Similarly, it will affect fixed-rate investors more. Since more inflation means these investors will get lower returns, inflation risk is crucial for them. If investors fail to consider the impact of inflation on their investments, they can suffer considerably. Due to the decrease in purchasing power, investors receive returns that have a lower value. That is despite receiving the same amount over the period. Inflation risk will always exist in any economy. Therefore, investors need to consider it when making investment decisions. Similarly, inflation risk doesn't only encompass the risk of inflation occurring. It is the risk that the inflation rate is higher than what investors anticipated. Since investors need to adjust for inflation beforehand, any difference between their estimate and actual inflation can also be critical. Overall, inflation risk plays a significant role in investments and the returns that investors get. ConclusionInflation risk is the risk that inflation may bring about adverse change with it. Similarly, it represents the risk that inflation occurs at a higher rate than anticipated. Inflation risk is crucial for both businesses and investors. Since inflation causes a decrease in a currency's purchasing power, inflation risk can affect long-term profitability. Article Source Here: What Is Inflation Risk? The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between systematic risk and anticipated returns. It is a model commonly used by companies to calculate their cost of capital. They may also use some other models. However, CAPM considers the systematic risk of investments, making it a prime choice for risky investments. There are some variations of the CAPM as well, such as the Fama-French Three-Factor Model. What is the Fama French 3 Factor Model?The Fama-French 3 Factor Model aims to extend the usefulness of the CAPM. This model considers two other factors apart from the systematic risk related to an investment. Most small-cap stocks outperform markets regularly. Similarly, high book-to-market value companies tend to outperform those with a low book-to-market value. The Fama-French model considers both possibilities. It does so by considering three factors. Firstly, it includes the market risk that CAPM already encompasses. In addition to that, it also reflects size risk and value risk. Therefore, this model extends on the CAPM functionality by considering crucial factors prevalent in the market. Since the Fama-French 3 factor model includes more risks, it also tweaks the formula used for CAPM. What is the formula for the Fama French 3 Factor Model?The Fama-French 3 factor model expands the original CAPM formula, which is as below. Expected Rate of Return = Risk-free Rate of Return + Market Risk Premium However, the above formula only considers the market risk. As mentioned, the Fama-French 3 factor model also includes two other risks, which are size risk and value risk. Therefore, the Fama-French 3 factor model formula is as below. Expected Rate of Return = Risk-free Rate of Return + Market Risk Premium + SMB + HML Mathematically, the formula for the model is as below. r = rf + β1(rm - rf) + β2(SMB) + β3(HML) Given below is what each of the symbols in the above formula represents. r = Expected rate of return rf = Risk-free rate of return β = Factor’s coefficient (rm - rf) = Market risk premium SMB (Small Minus Big) = Size premium HML (High Minus Low) = Value premium What is the Importance of the Fama French 3 Factor Model?The Fama-French 3 factor model explains more than 90% of the diversified portfolio's returns. In comparison, the CAPM only explains 70% of it. It considers any outperformance tendencies of the two types of stocks mentioned above. By including the two extra risk factors, the Fama-French 3 factor model provides more flexibility to investors. The model also explains that over a long time, investors get rewards for any losses they suffer in the short-term. Therefore, they can absorb any short-term volatility and periodic underperformances over a short period of time. Recently, there has been another variant of the Fama-French 3 factor model which considers even more factors. The Fama-French Five-Factor Model is a recent development based on the three-factor model that considers some additional factors. These include low volatility, momentum, and quality. Overall, the Fama-French model is crucial for investors looking to move beyond the traditional CAPM. ConclusionThe Capital Asset Pricing Model is a financial model that explains the relationship between systematic risk and anticipated returns. The Fama-French 3 Factor Model extends on CAPM’s functionality by considering two additional factors. These include size risk and value risk. This model is crucial for various reasons mentioned above. Post Source Here: Fama French 3 Factor Model |
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