Date of Award

6-2014

Document Type

Open Access

Degree Name

Bachelor of Arts

Department

Economics

First Advisor

James M. Kenney

Language

English

Keywords

profitability, appreciation, price, funds

Abstract

The purpose of this study is to analyze the relationship between gross profitability and share price appreciation. Dimensional Fund Advisors, an investment firm managing $338 billion, builds portfolios based on a number of different metrics and added gross profitability as a factor in early 2013. Profitable firms may be systematically undervalued and, therefore, gross profitability should predict future share price appreciation. Gross profitability is a firm’s gross profit multiplied by its asset turnover. A high gross profitability may signal a firm’s pricing power or quality in comparison with other businesses. Investors may neglect profitable firms and overpay for “lottery stocks” that have a small possibility of generating an outsized return. Novy‐Marx (2013) pairs gross profitability with value metrics to serve as a measurement of quality. His findings indicate that a portfolio built on gross profitability and value will deliver superior risk and return statistics. This study incorporates growth and risk metrics along with gross profitability to analyze their effects on share price appreciation. This study uses panel data on firms from the Russell 3000 Index over two separate time periods to investigate the effect of gross profitability on share price appreciation. Distinct time periods were chosen to analyze the effectiveness of gross profitability as a predictor of returns in differing macroeconomic climates. The first sample covers 618 cross-­‐sections from 1990 to 1997 and the second sample covers 1,629 firms from 2003 to 2012. Regression analyses are used to study the relationship between gross profitability and subsequent share price appreciation. Contrary to Novy‐Marx (2013) and Dimensional Fund Advisors (Goodman 2014), this study finds little to no relationship between gross profitability and share price appreciation. The most robust factor in this analysis is risk premium. This follows the efficient market hypothesis that higher risk should yield higher returns.

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