The Profitability Factor, Its Extensions, and Evidence from China

Abstract

This paper explores the profitability factor, its extensions, and evidence from the Chinese stock market. Profitability, defined as a firm's ability to generate earnings from existing resources, has strong theoretical foundations in asset pricing models, such as the Dividend Discount Model and q-theory. Empirical studies demonstrate that higher profitability correlates with higher expected stock returns, with Return on Equity (ROE) being the most widely used measure. The paper examines the sources of the profitability premium from both risk compensation and mispricing. It also discusses the relationship between profitability and other factors, such as quality, value, size, and low risk, highlighting their interactions and implications for investment strategies. Using data from the Chinese stock market, the study evaluates various profitability measures, including ROE, ROA, ROTC, ROIC, and RNOA, and their ability to predict returns. Additionally, the paper delves into related concepts such as earnings acceleration, post-earnings-announcement drift (PEAD), and earnings expectations management, providing insights into their relevance for asset pricing and portfolio construction. The findings offer a comprehensive perspective on the profitability factor and its role in the Chinese stock markets.

Keywords: profitability factor, factor investing, empirical asset pricing, PEAD

JEL Classification: G12