Profitability Context and the Cross-Section of Stock Returns

42 Pages Posted: 25 May 2023 Last revised: 5 Jul 2023

See all articles by Alex Kim

Alex Kim

University of Chicago Booth School of Business

Valeri V. Nikolaev

University of Chicago Booth School of Business

Date Written: May 25, 2023

Abstract

Asset pricing models implicitly assume that firm characteristics are context-free. At the same time, companies provide a substantial narrative context that helps investors to put numeric information in perspective. Management may discuss non-quantitative factors that influence performance, such as changes in competitive strategies, future plans, etc. We study the importance of contextual information for asset pricing by focusing on the narrative context surrounding profitability numbers. We use machine learning to incorporate contextual information into the measurement of profitability. Context-adjusted profitability has a superior ability to explain expected returns, both statistically and economically, compared to conventional operating profitability. Further, the context-adjusted profitability factor performs better in portfolio tests and helps to resolve the biggest challenge facing the five-factor model (Fama and French [2015]). Overall, we find that accounting for context adds significant value for investors and can improve the asset pricing models.

Keywords: Contextual information, context-based profitability, asset pricing, machine learning, natural language processing, operating profitability, factor models

JEL Classification: C13, C45, C55, C58, G11, G12, M41

Suggested Citation

Kim, Alex G. and Nikolaev, Valeri V., Profitability Context and the Cross-Section of Stock Returns (May 25, 2023). Chicago Booth Research Paper No. 23-11, University of Chicago, Becker Friedman Institute for Economics Working Paper No. 2023-76, Available at SSRN: https://ssrn.com/abstract=4459383 or http://dx.doi.org/10.2139/ssrn.4459383

Alex G. Kim

University of Chicago Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

Valeri V. Nikolaev (Contact Author)

University of Chicago Booth School of Business ( email )

5807 South Woodlawn Avenue
Chicago, IL 60637
United States

HOME PAGE: http://faculty.chicagobooth.edu/valeri.nikolaev/index.html

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