Question

This question pertains to market returns. How do you “standardize” industry returns to include them as a factor in analysis? I understand that for SMB and HML we don't subtract out the risk-free rate since those are giving us excess returns. Any kind of help for this question would be great.

Answer 1

Example of 3 factor model to calculated required rate
Suppose you estimate company market beta of 1.61, HML beta -0.02, SMB beta -1.05, RMW beta 0.92, and CMA beta -1.36. If the risk-free rate is 4%, expected market risk premium is 6%, expected HML return is 5%, expected SMB return is 3%, expected RMW return is 3%, and expected CMA return is 4%. Estimate Google’s expected return.

Expected Return of company=Risk Free Rate+Market Beta*Expected Market Risk Premium+HML Beta*Expected Return of HML+SMB beta*Expected Return of SMB+Beta of RMW*Return of RMW+Beta of CMA*Return of CMA
=4%+1.61*6%-0.02*5%-1.05*3%+0.92*3%-1.36*4% =7.73%