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

Abstract

We use a simple two-stage growth model to connect profitability growth to returns. In this framework, both the magnitude and the length of the first-stage growth play a key role in determining returns. Using current profitability growth to estimate magnitude and firm size to estimate the inverse of length, we predict that future returns should be increasing in current profitability growth, but the effect should diminish with firm size. Across a range of empirical tests, we find strong evidence in support for our hypotheses. The predictive effects are not subsumed after controlling for an array of associated, potentially confounding variables.

Keywords: Profitability Growth; Firm Size; Stock Returns

JEL Classification: G11; G12