Why Does Operating Profitability Predict Returns? New Evidence on Risk versus Mispricing Explanations

60 Pages Posted: 29 Sep 2023

See all articles by Anwer S. Ahmed

Anwer S. Ahmed

Texas A&M University - Mays Business School

Michael Neel

University of North Texas - Department of Accounting

Irfan Safdar

Widener University

Multiple version iconThere are 2 versions of this paper

Date Written: September 9, 2023

Abstract

This study develops new evidence on risk versus mispricing explanations of the well-known profitability premium. First, we examine whether exposure to expected downside risk is a plausible explanation. We find that high profitability is associated with both lower ex-ante and ex-post probabilities of future price crashes. Thus, less profitable firms exhibit greater downside risk than highly profitable firms, making a downside risk explanation implausible. Although this fact is overlooked by the market in general, it is anticipated by options traders; we find that put options of low profitability firms are relatively more expensive. Simultaneously, these firms do not exhibit greater probability of jumps, indicating that volatility(risk)-based explanations for the profitability premium are unlikely to be descriptive. Second, we find that the sticky-expectations model of Bouchard et al. (2019) only partially explains the profitability premium. While on average, analysts’ forecast revisions correct in the same direction as recent profitability, the profitability premium still exhibits a strong relationship to the non-sticky component of analysts’ forecast revisions. Third, institutional investors trade profitability-based signals but do so with a delay, likely contributing to the premium. Overall, our evidence favors the explanation that the profitability premium is related to investor mispricing of potential downside risk and provides greater clarity on recent findings in the literature.

Keywords: Profitability premium, Operating profitability, Stock Returns, Expected Crash Risk, Underreaction

JEL Classification: G11, G12, M41

Suggested Citation

Ahmed, Anwer S. and Neel, Michael and Safdar, Irfan, Why Does Operating Profitability Predict Returns? New Evidence on Risk versus Mispricing Explanations (September 9, 2023). Available at SSRN: https://ssrn.com/abstract=4567087 or http://dx.doi.org/10.2139/ssrn.4567087

Anwer S. Ahmed

Texas A&M University - Mays Business School ( email )

430 Wehner
College Station, TX 77843-4353
United States

Michael Neel (Contact Author)

University of North Texas - Department of Accounting ( email )

College of Business Administration
P.O. Box 305219
Denton, TX 76203
United States

Irfan Safdar

Widener University ( email )

Chester, PA 19013
United States

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