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

Abstract

The change in a firm’s profitability, or profitability growth (PG), has incremental power to predict stock returns over profitability level and other well-known cross-sectional determinants. Remarkably, the Fama and French five-factor alpha on a long-short strategy based on PG is 0.73% per month. This strategy remains highly profitable even for the top 20% largest firms and the significant risk-adjusted returns can also be attained with long-only positions. PG either subsumes or largely weakens the predictive power of other well-known, earnings-based signals on future returns at short- and intermediate terms. The PG effect is consistent with firm-valuation models featuring persistent earnings growth and compensation for expected growth-rate risk. An augmented Fama and French three-factor model that includes a PG factor captures the momentum anomaly at least as well as other prominent factor models

Keywords: Profitability; Growth; Return Predictability; Stock Returns

JEL Classification: G11; G12