Capacity Constraints, Profit Margins and Stock Returns

38 Pages Posted: 5 Dec 2009  

Bjorn Jorgensen

London School of Economics & Political Science (LSE) - Department of Accounting

Gil Sadka

University of Texas at Dallas

Jing Li

The University of Hong Kong - School of Business

Date Written: November 9, 2009

Abstract

This paper studies the effects of capacity utilization on accounting profit margins and stock returns. Since accounting profit margins represent the average profit per unit and not the economists' concept of unit contribution margin, the marginal/variable profit per unit, a firm with idle capacity can increase its profit margins by increasing sales (output). But, if the firm is operating at full capacity, an increase in output must be preceded by an increase in capacity (and fixed costs resulting in lower profit margins. Our empirical findings suggest that firms' profit margins increase in sales when there is idle capacity, but decreases in sales when the firm approaches full capacity. We show that firms experiencing high growth in sales operating in industries with high capacity utilization experience abnormally low stock returns in the following period.

Keywords: accounting valuation, abnormal returns, capacity constraint, profitability, profit margins

JEL Classification: E32, G12, G14, M41

Suggested Citation

Jorgensen, Bjorn and Sadka, Gil and Li, Jing, Capacity Constraints, Profit Margins and Stock Returns (November 9, 2009). Available at SSRN: https://ssrn.com/abstract=1517959 or http://dx.doi.org/10.2139/ssrn.1517959

Bjorn N Jorgensen

London School of Economics & Political Science (LSE) - Department of Accounting ( email )

Department of Accounting Room, OLD 2.17
Houghton Street
London, WC2A 2AE
United Kingdom

Gil Sadka (Contact Author)

University of Texas at Dallas ( email )

2601 North Floyd Road
Richardson, TX 75083
United States

Jing Li

The University of Hong Kong - School of Business ( email )

Meng Wah Complex
Pokfulam Road
Hong Kong
China

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