Explaining the Profitability Anomaly

43 Pages Posted: 7 Aug 2019 Last revised: 12 Jun 2020

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: June 11, 2020

Abstract

We provide a new explanation for the profitability anomaly along with a battery of supportive empirical tests. Our explanation is based on the observation that investors frequently value stocks by assigning similar price-to-earnings multiples to stocks with similar expected firm growth. This naive approach to valuation results in a positive relation between profitability and future stock returns, and the relation is stronger in firms with higher 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 earnings and cash flows.

Keywords: Profitability, Anomalies, Valuation, Multiples, Dilution

JEL Classification: G11, G12, G14, M41

Suggested Citation

Erhard, Ryan and Sloan, Richard G., Explaining the Profitability Anomaly (June 11, 2020). 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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