Abstract

http://ssrn.com/abstract=2414543
 


 



Deflating Profitability


Ray Ball


University of Chicago

Joseph Gerakos


University of Chicago - Booth School of Business

Juhani T. Linnainmaa


University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)

Valeri V. Nikolaev


University of Chicago - Booth School of Business

August 12, 2014

Journal of Financial Economics (JFE), Forthcoming
Chicago Booth Research Paper No. 14-10
Fama-Miller Working Paper

Abstract:     
Gross profit scaled by book value of total assets predicts the cross-section of average returns. Novy-Marx (2013) concludes that it outperforms other measures of profitability such as bottom-line net income, cash flows, and dividends. One potential explanation for the measure’s predictive ability is that its numerator - gross profit - is a “cleaner” measure of economic profitability. An alternative explanation lies in the measure’s deflator. We find that net income equals gross profit in predictive power when they have consistent deflators. Deflating profit by the book value of total assets results in a variable that is the product of profitability and the ratio of the market value of equity to the book value of total assets, which is priced. We then construct an alternative measure of profitability, operating profitability, which better matches current expenses with current revenue. This measure exhibits a far stronger link with expected returns than either net income or gross profit. It predicts returns as far as ten years ahead, seemingly inconsistent with irrational pricing explanations.

Number of Pages in PDF File: 55

Keywords: Gross profitability, operating profitability, asset pricing, deflators, earnings anomalies

JEL Classification: G12, M42

Accepted Paper Series





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Date posted: March 27, 2014 ; Last revised: October 10, 2014

Suggested Citation

Ball, Ray and Gerakos, Joseph and Linnainmaa, Juhani T. and Nikolaev , Valeri V., Deflating Profitability (August 12, 2014). Journal of Financial Economics (JFE), Forthcoming; Chicago Booth Research Paper No. 14-10; Fama-Miller Working Paper. Available at SSRN: http://ssrn.com/abstract=2414543 or http://dx.doi.org/10.2139/ssrn.2414543

Contact Information

Ray Ball
University of Chicago ( email )
5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-834-5941 (Phone)
773-702-0458 (Fax)
Joseph J. Gerakos (Contact Author)
University of Chicago - Booth School of Business ( email )
5807 S. Woodlawn Ave.
Chicago, IL 60637
United States
773-834-6882 (Phone)
Juhani T. Linnainmaa
University of Chicago - Booth School of Business ( email )
5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
(773) 834-3176 (Phone)
(773) 753-1052 (Fax)
HOME PAGE: http://faculty.chicagobooth.edu/juhani.linnainmaa
National Bureau of Economic Research (NBER) ( email )
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Valeri V. Nikolaev
University of Chicago - Booth School of Business ( email )
5807 South Woodlawn Avenue
Chicago, IL 60637
United States
Feedback to SSRN


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