The Value of Growth: Changes in Profitability and Future Stock Returns

Abstract

We use a simple two-stage dividend growth model to connect profitability growth
and firm scale to stock returns. In this framework, both the magnitude and the length of the
first-stage growth play a key role in determining returns. Using current profitability growth to
estimate magnitude and firm scale as inverse proxy for length, we predict that future returns
should increase with current profitability growth but, crucially, the effect should diminish with
firm scale. Across a range of empirical tests, we find strong evidence in support of our model
determinants and predictions. Our findings are not explained by an array of associated,
potentially confounding variables.

Keywords: Profitability Growth; Firm Size; Stock Returns

JEL Classification: G11; G12