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

Abstract

We provide a novel framework and empirical results to understand the relation between profitability growth and returns. By connecting a concave profit function to a standard valuation framework, we argue that if growth-rate risk carries a positive risk premium, firms with higher current profitability growth should earn higher average returns but this effect should decrease with firm scale. Across a range of empirical tests, we find strong evidence in support of our hypotheses. Moreover, the predictive effects of profitability growth and its interaction with scale are not subsumed after controlling for an array of associated, potentially confounding variables.

Keywords: Profitability; Growth; Return Predictability; Stock Returns

JEL Classification: G11; G12