Deflating Profitability

55 Pages Posted: 27 Mar 2014 Last revised: 12 Dec 2015

Ray Ball

University of Chicago - Accounting

Joseph J. Gerakos

Tuck School of Business at Dartmouth College

Juhani T. Linnainmaa

USC Marshall School of Business; National Bureau of Economic Research (NBER)

Valeri V. Nikolaev

University of Chicago Booth School of Business

Date Written: August 12, 2014

Abstract

Gross profit scaled by book value of total assets predicts the cross-section of average returns. Novy-Marx (2013) concludes that it outperforms other measures of profitability such as bottom-line net income, cash flows, and dividends. One potential explanation for the measure’s predictive ability is that its numerator - gross profit - is a “cleaner” measure of economic profitability. An alternative explanation lies in the measure’s deflator. We find that net income equals gross profit in predictive power when they have consistent deflators. Deflating profit by the book value of total assets results in a variable that is the product of profitability and the ratio of the market value of equity to the book value of total assets, which is priced. We then construct an alternative measure of profitability, operating profitability, which better matches current expenses with current revenue. This measure exhibits a far stronger link with expected returns than either net income or gross profit. It predicts returns as far as ten years ahead, seemingly inconsistent with irrational pricing explanations.

Keywords: Gross profitability, operating profitability, asset pricing, deflators, earnings anomalies

JEL Classification: G12, M42

Suggested Citation

Ball, Ray and Gerakos, Joseph J. and Linnainmaa, Juhani T. and Nikolaev , Valeri V., Deflating Profitability (August 12, 2014). Journal of Financial Economics (JFE), Volume 117, Issue 2, pp. 225-248; Fama-Miller Working Paper; Chicago Booth Research Paper No. 14-10. Available at SSRN: https://ssrn.com/abstract=2414543 or http://dx.doi.org/10.2139/ssrn.2414543

Ray Ball

University of Chicago - Accounting ( email )

Joseph J. Gerakos (Contact Author)

Tuck School of Business at Dartmouth College ( email )

Hanover, NH 03755
United States

Juhani T. Linnainmaa

USC Marshall School of Business ( email )

Marshall School of Business
Los Angeles, CA 90089
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Valeri V. Nikolaev

University of Chicago Booth School of Business ( email )

5807 South Woodlawn Avenue
Chicago, IL 60637
United States

HOME PAGE: http://faculty.chicagobooth.edu/valeri.nikolaev/index.html

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