Profitability and Stock Returns in Production-Based Asset Pricing with Decreasing Returns to Scale

Abstract

Production decisions provide a credible indicator of future costs of capital perceived by corporate insiders and so may forecast future stock returns. We find that, under decreasing returns to scale, investment returns correlate imperfectly with stock returns and that higher profitability and traditional value are both associated with higher chosen risk exposure. Capital investment and utilization predict profitability and future returns. Empirically, utilization approximated by electricity usage has clear forecast power for returns, complementing the established forecast power of investment. In addition, book-to-market ratios forecast returns, with specific predicted exceptions. The production-based model with decreasing returns predicts costs of capital better than traditional asset pricing models.

Keywords: Profitability, Stock returns, Production-based asset pricing, Investment returns, Capacity utilization, Decreasing returns to scale

JEL Classification: G12