eThesis - School of Business electronic theses

BACKGROUND AND OBJECTIVES:

Prior research has observed that asset growth and profitability are related to future average stock returns. Furthermore, asset growth and profitability factors have been identified to capture cross-sectional return variation in the stock market. To understand the reasons behind asset growth discount and profitability premium, this paper focuses on predicting their time-varying returns in the US stock market by using implied cost of capital method.

DATA AND METHODOLOGY:

The sample group of companies includes Standard & Poor's (S&P) 500 index constituents from the beginning of 1977 to the end of 2014. The company specific data is gathered from Institutional Brokers' Estimate System (IBES), Centre of Research in Security Prices (CRSP), and Computstat. This paper implements multiperiod predictive regressions on the asset growth discount and the profitability premium to assess how different risk and mispricing related factors contribute to their future returns. The implied cost of capital (ICC) method, which utilises equity analysts' earnings estimates and current market valuations, is used to measure investors' required rate of return for different companies. Both uni- and multivariate regressions are performed with different ICC measures, business cycle variables and an investor sentiment index as predictors. Finally, alternative weighting method and portfolio size are tested as robustness checks.

MAIN FINDINGS:

Investors rationally expect higher returns from low asset growth than from high asset growth companies, since the spread in their ICC measures has historically been positive and it positively predicts future asset growth discount. This finding supports the risk-based explanation for the asset growth discount. However, the asset growth discount also has a time-varying mispricing component as the investor sentiment influences its return variation. Market irrationality seems to be a major contributor to the positive relation between profitability and future returns. Despite low profitability companies generate lower returns than high profitability companies, investors expect higher returns from low profitability companies ex-ante. Additionally, low profitability companies are more sensitive to countercyclical price of risk, implying they should earn higher average returns than high profitability companies. These findings suggest mispricing has a substantial effect in the profitability premium. The investor sentiment measure, however, is not highly significant predictor of the anomaly's future returns. Therefore, the source of the mispricing is left unexplained.