Explaining the Profitability Anomaly

39 Pages Posted: 7 Aug 2019 Last revised: 19 Nov 2019

See all articles by Ryan Erhard

Ryan Erhard

University of Southern California - Leventhal School of Accounting

Richard G. Sloan

University of Southern California - Leventhal School of Accounting

Date Written: November 16, 2019

Abstract

We provide a new explanation for the profitability anomaly. Our explanation is based on the observation that investors frequently value stocks by assigning similar price-to-earnings multiples to firms with similar expected growth. We show that this naive approach to valuation results in lower future stock returns for less profitable firms and that this relation is concentrated in firms with higher expected growth. The relation arises because less profitable firms must issue additional equity in the future to finance growth, thus diluting the claims of existing stockholders to future cash flows. Using a battery of empirical tests, we show that investors and analysts do not appear to anticipate the higher future dilution in less profitable growth firms and that this appears to explain the profitability anomaly.

Keywords: Profitability, Anomalies, Valuation, Multiples, Dilution

JEL Classification: G11, G12, G14, M41

Suggested Citation

Erhard, Ryan and Sloan, Richard G., Explaining the Profitability Anomaly (November 16, 2019). Available at SSRN: https://ssrn.com/abstract=3431482 or http://dx.doi.org/10.2139/ssrn.3431482

Ryan Erhard (Contact Author)

University of Southern California - Leventhal School of Accounting ( email )

Los Angeles, CA 90089-0441
United States

Richard G. Sloan

University of Southern California - Leventhal School of Accounting ( email )

Los Angeles, CA 90089-0441
United States

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