Digging Into The Profitability Premium

It has been well-documented that profitability is positively correlated with stock returns. Firms with higher profits earn higher returns. The profitability factor has also been shown to eliminate most of the well-known anomalies that can represent problems for the Fama-French four-factor model (i.e., returns that cannot be explained by exposure to the factors of beta, size, value and momentum). Thus, it has been incorporated into the newer factor models, including both the Fama-French five-factor model and the q-factor model.

Several papers have examined the issue of whether the profitability premium is the result of a risk premium or mispricing. Ryan Liu contributes to the literature on this subject through his November 2015 study, “Profitability Premium: Risk or Mispricing?”, which covered the period July 1963 through 2013.

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