Abstract
Macroeconomic risks only partially capture the profitability premium, while adding a misvaluation factor based on investor sentiment helps explain a substantial amount of it. The profitability premium mainly exists in firms whose market valuations are inconsistent with their profitability and therefore subject to ex-ante expectation errors during high sentiment periods. Direct evidence shows that firms with high profitability but low market valuation have significantly higher abnormal earnings announcement returns, analyst earnings forecast errors and forecast revisions than firms with low profitability but high market valuation. Return decomposition further confirms that the profitability premium is driven by the unexpected cash-flow component.
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