Pricing Effect of Restaurant Industry Related Factors on Fama French Three Factor Model

The purpose of this study was to investigate the effect of the addition of restaurant industry-related factors on the accuracy and explanatory power of the Fama-French three factor model when estimating the risk and expected return of restaurant firms. Restaurant industry related factors are variables that may have an influence on the restaurant industrys risk that cannot be diversified away in a portfolio of restaurant firms. Four factors that may affect the restaurant industrys systematic risk were selected. These factors are (1) inability to take advantage of outsourcing to the extent that other industries can, (2) impact of labor intensity, (3) effect of the real estate component of restaurant companies and limited alternative usage of their physical structures, and (4) customers eating out behavior. While some of these factors would also affect other service industries, it is the cluster of these factors that together may set the restaurant industry, part of the hospitality industry, apart from most other industries. Several proxies were determined to measure each factor. The rationale of focusing on the Fama-French model as the asset pricing model while other asset pricing models exist is the documented better performance of this model compared to other established asset pricing models.The hypothesis that the Fama-French three factor model with the addition of restaurant industry related factors would provide a more accurate estimate of the restaurant industrys risk and its expected return than the classic Fama-French three factor model was tested using seemingly unrelated regression. The analysis shows that the Fama French model fails to explain the variation in returns in a specific industry like the restaurant industry although it performs very well for the market and on portfolio basis. Connor and Korajczyk (1993) argued that companies in the same industry might have industry specific components to their returns, which may not be pertinent for the entire economy. This study confirms that there are industry related influences that affect a specific industrys (in this case, the restaurant industry) systematic risk and its expected returns. Furthermore these influences are not captured in standard asset pricing models like the Fama French model.