Explaining the Profitability Anomaly

Abstract

We provide a new explanation for the profitability anomaly along with a battery of supportive empirical tests. Our explanation is based on the observation that investors frequently value stocks by assigning similar price-to-earnings multiples to stocks with similar expected firm growth. This naive approach to valuation results in a positive relation between profitability and future stock returns, and the relation is stronger in firms with higher growth. The relation arises because less profitable firms must issue additional equity in the future to finance growth, thus diluting the claims of existing stockholders to future earnings and cash flows.