Abstract
This paper provides an extensive international analysis of the cross-sectional return predictive power of a variety of firm-level profitability measures, calculated from different combinations of measures of earnings and scaling variables. We show that this cross-sectional predictive relation is more pronounced when profit is measured by gross profit and when profits are scaled by enterprise value or market value of equity. Our findings support the hypotheses that the predictive power of “profits-to-market price” factor is partly attributable to stock mispricing arising from systematic behavioral biases and partly to the choice of a “clean” measure of earnings.
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Notes
Chiu and Haight (2020) show that modified earnings variables with lower susceptibility to signal weakening due to investors’ learning exhibit rates of return attenuation that are 30–64% lower than rates for bottom-line earnings variables. They conclude that while investor learning is apparent in the data, learning efforts to date have been suboptimal at exploiting profitability signals within firms’ earnings streams.
Novy-Marx (2013) uses book assets as the deflator and argues that “scaling by a market based measure conflates the productivity proxy with book-to-market”. We feel that this is ultimately an empirical question.
OI of a bank is measured as total interest income plus non-interest income, minus total interest expense, non-interest expense and provision for loan losses.
EBIT as pre-tax income plus interest expense on debt minus interest capitalized.
For firms with more than one type of ordinary shares, ME represents the product of the price per share of the primary issue and the sum of listed and unlisted common equivalent shares.
For banks, insurance companies and all other industries, cash represents cash and due from banks, cash, and cash and short term investments, respectively.
Throughout the paper, we calculate t-statistics (t-stat) using the Newey-West (1987) procedure with six lags. We use 5% as our statistical significance level and present significant values in bold.
To save space in the paper, we report the average slope coefficients of the profitability variables. The results of the control variables are available upon request.
These findings are consistent with Chiao et al. (2005) who show that firm size and book-to-market effects cannot fully explain the cross-sectional return variation driven by investors’ mispricing in the Japanese stock market.
We focus on the North American sample because the mispricing factors are not available for other regions.
We focus on the four profitability variables with earnings measured by gross profit (GP) in this section because Sect. 4 shows that the return predictive power of the other profitability proxies with earnings measured by operating income (OI) and EBIT are statistically insignificant for the North American sample.
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The authors gratefully acknowledge the Summer Research Grants from the Gabelli School of Business.
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Cakici, N., Chatterjee, S., Tang, Y. et al. Alternative profitability measures and cross-section of expected stock returns: international evidence. Rev Quant Finan Acc 56, 369–391 (2021). https://doi.org/10.1007/s11156-020-00897-7
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DOI: https://doi.org/10.1007/s11156-020-00897-7