Dissecting the Profitability Premium

Abstract:     
Previous studies show that the profitability-based factor can explain almost all asset pricing anomalies, highlighting the importance of firm profitability. This paper investigates both risk-based and behavioral-based explanations of the profitability premium itself. First, we show that there is moderate support for risk-based structural models with shareholder advantage and investment flexibility. Second, the profitability premium exists primarily among firms with high arbitrage costs or high information uncertainty. Third, the majority of the profitability premium is derived from the negative alpha of low profitability firms, consistent with the notion that overpricing is more
prevalent than underpricing due to greater impediments to short. Finally, portfolio return behavior around earnings announcements suggests that investor underreaction and limits-to-arbitrage are partially responsible for the profitability premium.

Number of Pages in PDF File: 45

Keywords: profitability, anomaly, limit of arbitrage, information uncertainty

working papers series