Industry Effects on Firm and Segment Profitability Forecasting: Do Aggregation and Diversity Matter?

Abstract

Academics and practitioners have long recognized the importance of a firm’s industry membership in explaining its financial performance. Yet, contrary to conventional wisdom, recent research shows that industry-specific profitability forecasting models are not better than economy-wide models. This paper re-examines the incremental advantage of industry-specific models. We find considerable industry effects in profitability forecasting. However, the effects are only visible for focused firms. For diversified firms, aggregated reporting at the firm level prevents the effects from being observed. Furthermore, to reliably extract industry patterns from the data, industry classifications have to be sufficiently broad – otherwise industry-specific profitability forecasts are too noisy to improve forecast accuracy. Additional analysis shows that industry effects in profitability forecasting can be profitably exploited by market participants.