Explaining the Profitability Anomaly
39 Pages Posted: 7 Aug 2019 Last revised: 19 Nov 2019
Date Written: November 16, 2019
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
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