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Best Profitability Metric for Predicting Stock Returns?

Posted in Equity Premium

Is there a best way for investors to measure firm profitability for global stock selection? In their August 2018 paper entitled "Constructing a Powerful Profitability Factor: International Evidence", Matthias Hanauer and Daniel Huber investigate which measure of firm profitability best predicts associated stock returns. They consider six measures: return on equity; gross profitability; operating profitability calculated in two ways; cash-based operating profitability (excluding accruals); and, cash-based gross profitability (also excluding accruals). They construct a long-short profitability factor for each measure and test its power to predict stock returns both standalone and in combination with other kinds of factors (market, size, book-to-market, momentum, investment and accruals) and the other profitability factors. Using monthly returns and annual accounting data for non-financial common stocks in 49 countries (excluding the U.S.) during July 1989 through June 2016, they find that:

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