Mispricing Underlies Profitability Premium

It has been well-documented that profitability is positively correlated with stock returns—firms with higher profits earn higher returns. The question that we will ask today about the profitability premium relates to its source: Is it based on risk? Or, is it an anomaly that results from persistent pricing errors?

F.Y. Eric Lam, Shujing Wang and K.C. John Wei contribute to the literature with their January 2015 study, “The Profitability Premium: Macroeconomic Risks or Expectation Errors?” Lam, Wang and Wei explored two alternative explanations for the profitability premium—the rational explanation based on macroeconomic risks and the mispricing explanation attributed to expectation errors.

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