The Value of Growth: Changes in Profitability and Future Stock Returns

Abstract

The dividend-discount model predicts a positive relation between expected changes in a firm’s profitability, or profitability growth, and stock returns. We find this prediction to be borne out in the data. Across U.S. stocks, firms with strong past profitability growth outperform firms with weak past profitability growth. A long-short strategy based on profitability growth yields significant risk-adjusted returns, both in the overall sample and across firm-size levels. The predictive power of profitability growth is economically strong and statistically significant when compared with well-documented, cross-sectional determinants such as profitability levels, earnings momentum, profit trend, size, book-to-market, or price momentum.

Keywords: Profitability; Growth; Return Predictability; Stock Returns

JEL Classification: G11; G12