Permanence of Abnormal Returns and Possible Applications for Company Valuation: Empirical Study of Profitability Sustainability and Fade Rates in the US Capital Market and Suggested Incorporation into Valuation Models

Abstract

Empirical experience and microeconomic theory suggest that abnormal profit margins fade show a mean reversion trend within a certain amount of time. The present empirical study analyzes this phenomenon on the basis of the publicly available data of more than 10,000 US-listed companies since 1965. By fitting an autoregressive exponential decay AR(1) model, the authors find further support that this fading exists in abnormal profitability, measured by Cash Flow Return on Investment. In contrast to prior findings, however, the fade proves to not al-ways be complete: top performing companies manage to sustain a competitive advantage over time. Also, the speed of the mean reversion is differing over time and generally higher for in-ferior than for superior profitability. This quantification of fade parameters and fade-to levels opens new perspectives for the theory of company valuation in two ways: one, outside-in valuations can be brought closer to reality by using the fade methodology instead of simple multiples, and two, the terminal value determination in discounted cash flow (DCF) models can be improved because terminal year behavior could be modeled in a more differentiated way.

Keywords: Valuation, Mean Reversion, Profitability Fade, Competitive Advantage

JEL Classification: C22 ,C23, G12, D40