Life Cycle Models and Forecasting Growth and Profitability

• In Event: Forecasting Profitability

Abstract

Mean reversion in profitability and growth is a well-documented phenomenon in prior literature. However, we know comparatively less about the underlying process that drives such mean reversion. While prior literature documents that assuming industry-level mean reversion improves forecasts of firm growth, it shows that forecasts of firm profitability are better modeled using economy-wide parameters. In this study, we investigate the relative forecast accuracy of mean reverting models based on firm life cycle. Given that life cycle is recognized to have a substantial impact on firm-decision making and firm profitability, assuming that firms’ profitability and growth parameters revert to the mean for their respective life cycle may lead to more accurate out-of-sample forecasts. Consistent with this expectation we find that life cycle models improve forecast accuracy of growth and profitability forecasts, outperforming economy-wide and industry-specific models in forecasting a wide range of profitability and growth measures in the short-term and the long-term. We also find that analysts underutilize the life cycle information and that life cycle forecasts are associated with future abnormal stock returns.

Authors

• Patrick Vorst, Indiana University - Bloomington

• Teri Lombardi Yohn, Indiana University - Bloomington