Expected profitability and the cross-section of stock returns

Abstract

Both the investment CAPM and the dividend discount model posit that expected profitability should positively predict future stock returns in the cross section, all else equal. However, previous studies generally use past profitability as a proxy for expected profitability when constructing factor models. In this paper, we reexamine the role of expected profitability and present three new empirical facts: First, past profitability measures are not appropriate proxies for expected profitability. Second, consistent with the theories, expected profitability is found to be important in describing average stock returns. Third, the expected profitability factor based on the Ball et al. (2016) measure outperforms those based on expected operating and net profits, as in Fama and French, (2015, 2016) and Hou et al. (2015).