Alternative Profitability Measures and Cross Section of Expected Stock Returns: International Evidence

Abstract

This paper provides an extensive international analysis of the cross-sectional return predictive power of a variety of firm-level profitability measures, calculated from different combinations of three important measures of earnings (gross profit, operating income, and EBIT) and four scaling variables (enterprise value, book value of assets, market value of equity, and book value of equity). The sample covers stock-returns data over the period 1991-2016 from four regions in the world: North America, Europe, Japan and Asia Pacific. Regarding the scaling measure, we find that irrespective of the choice of a profit measure, the cross-sectional predictive relation of firm profitability and stock returns is more pronounced when profits are scaled by enterprise value or market value of equity. Regarding the profit measure, we find that the predictive power is more pronounced when profit is measured by gross profit. Our findings are consistent with the hypotheses that the predictive power of “profits-to-market price” factor is partly attributable to stock overvaluation arising from systematic behavioral biases and partly to the choice of a “clean” measure of earnings.

Keywords: Profitability, enterprise value, behavioral finance, international asset pricing

JEL Classification: G11, G12, G15