Equity returns, corporate profitability, the value premium and dynamic models of equity valuation

This dissertation investigates the relation between equity returns and profitability. I develop several dynamic equity valuation models that have the common characteristic that a value maximizing manager suspends corporate growth upon low profitability. Profitability increases the likelihood of future growth which engenders risk and increases return. Thus, over some range of profitability, returns and profitability relate positively. I use these dynamic equity valuation models to investigate a number of hitherto unexplained phenomena in equity markets. These phenomena are all related to the “value-premium” which is the empirical observation that low market/book “value” stocks have higher returns than high market/book “growth” stocks. First, I propose a new explanation for the value-premium: the “limits-to-growth hypothesis.” With organizational limits on growth expenditure, profitability decreases risk for high profitability “growth” firms but increases risk for low profitability “value” firms in anticipation of future growth-leverage. Consistent with a modified version of the limits-to-growth hypothesis, I find that profitability increases returns to a greater extent for value compared to growth firms. Second, I find no evidence of limited growth opportunities that would otherwise induce low returns for high profitability non-dividend paying companies. Non-dividend paying firms do not face the same growth limits as dividend paying firms. They finance growth investments internally only as profitability permits. These investments increase risk and return. Consistent with this prediction, I find high returns for high profitability, high market/book, growth stocks, which is a negative value-premium for non-dividend paying stocks. Third, I show that distress-risk is part of the reason for the value-premium despite the commonly reported anomalous observation that high distress-risk firms have low returns. Profitability impacts two risks in opposite ways. Profitability decreases distress-risk but increases growth-leverage. Thus, high profitability firms with low distress-risk and high growth-leverage can have higher returns than low profitability firms with high distress-risk and low growth-leverage. The value-premium for firms in financial distress arises from a U-shaped relation between returns and profitability and a hill-shaped relation between market/book and profitability. When market/book is low (high or low profitability), returns are high.