Firm Profitability: Mean-Reverting or Random-Walk Behavior?
36 Pages Posted: 7 Apr 2012 Last revised: 29 May 2014
Date Written: February 24, 2012
We analyze the stochastic properties of three measures of profitability, return on assets (ROA), return on equity (ROE), and return on investment (ROI), using a balanced panel of US firms during the period 2001-2010. We employ a panel unit-root approach, which assists in identifying competitive outcomes versus situations that require regulatory intervention to achieve more competitive outcomes. Based upon conventional panel unit-root tests, we find substantial evidence supporting mean-reversion, which, in turn, lends support to the long-standing “competitive environment” hypothesis originally set forward by Mueller (1976). These results, however, prove contaminated by the assumption of cross-sectional independence. After controlling for cross-sectional dependence, we find that profitability persists indefinitely across some sectors in the US economy. These sectors experience extremely slow, or non-existent, mean-reversion.
Keywords: Cross-sectional dependence, unit roots, panel data, hysteresis, firm profitability
JEL Classification: C23, D22, L25
Suggested Citation: Suggested Citation
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By Yuxing Yan