Rigorous research on what drives stock and bond returns has been part of Dimensional’s DNA since day one. A profound understanding of what drives differences in expected returns allows us to provide our clients with robust, value-added investment solutions that pursue higher expected returns in a systematic and cost-efficient manner.
Dimensional’s work on the profitability premium shows that measures of current profitability contain reliable information about future profitability and, consequently, about expected returns.1 Our research identifies operating profitability—defined as operating income before depreciation and amortization minus interest expense, scaled by book equity—as a comprehensive measure of profitability that captures major business expenses and revenues across various sectors. We use this measure of profitability to target the profitability premium across our equity strategies.
Some researchers have argued that profitability measures should discriminate between different types of earnings. Proponents of cash profitability measures believe accruals should be subtracted from operating profits, as these components of earnings have been negatively related to future stock returns. Our latest study takes a deeper look at accruals and cash profitability to see whether this adjustment offers a more reliable way to capture the profitability premium.
There are two primary questions to answer when assessing cash profitability. First, does it proxy for future profitability more reliably than operating profitability? And second, does it predict differences in stock returns more effectively than operating profitability? Fama- MacBeth regressions testing these imply the answer to both questions is no. The data suggest cash profitability does not contain more information about future profitability and returns than operating profitability.
Our analysis also shows that there is a negative relation between accruals and subsequent stock returns, but it is mainly driven by the underperformance of small cap high accrual firms, which also tend to be high investment firms. Therefore, emphasizing firms with higher cash profitability effectively applies an underweight to high investment stocks. Past research by Dimensional has already highlighted the benefit of investment considerations in small cap strategies.2,3 Controlling for the investment effect, the performance of small cap firms with high cash profitability is not reliably different from that of small cap firms with high operating profitability.
Our work on cash profitability underscores some important themes for research on expected returns. New variables (or tweaks on existing variables) cannot be evaluated in a vacuum. They must be evaluated in the context of other drivers of expected returns. What looks like an advantage for cash profitability (an indirect consideration for investment) may not be additive if implemented in a strategy that already employs investment considerations. Furthermore, having separate measures of the profitability and investment premiums rather than a single measure that combines them would allow investors to more efficiently target these premiums and effectively manage the interactions between them.
1. O’Reilly, Gerard and Savina Rizova. “Expected Profitability: A New Dimension of Expected Returns” (white paper, Dimensional Fund Advisors, 2013).
2. Rizova, Savina and Namiko Saito. “Investment and Expected Stock Returns” (white paper, Dimensional Fund Advisors, 2019).
3. Rizova, Savina and Namiko Saito. “Implementing the Investment Premium: Small High Asset Growth Exclusion” (white paper, Dimensional Fund Advisors, 2019).
Profitability premium: The return difference between stocks of companies with high profitability over those with low profitability.
Operating profitability: Operating income before depreciation and amortization minus interest expense, scaled by book equity.
Cash profitability: Operating income before depreciation and amortization minus interest expense and accruals, scaled by book equity.
Accruals: Changes in accounts receivable, inventory, and prepaid expenses, minus changes in accounts payable, deferred revenue, and accrued expenses.
High investment firms: Companies with high recent growth in assets.
Investment premium: The return difference between stocks of companies with low recent asset growth over those with high recent asset growth.
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