The Usefulness of Profits for Portfolio Allocation: Persistence, Predictive Value, and Value Relevance

• In Event: Auditing and Investing
  In Paper Session: Auditing and Investing Research

Abstract

This paper investigates why operating profit explain future stock returns and cash flows. Using Ohlson’s three attributes of usefulness: persistence, predictive value and value relevance, we show that operating profit is substantially more persistent and forecastable in real time than net income. Innovations in operating profit have significantly greater explanatory power for future net income or cash flow than net income, cash flow or gross profits, and hence have superior predictive value.
Out-of-sample procedures further evaluate the relationships between predicted accounting variables
and excess returns at the industry level to assess which accounting metric can best identify
industries that yield either high or low returns. A portfolio allocation strategy that takes long
positions in high performing industries and shorts poorly performing industries based on operating
profit outperforms the buy-and-hold benchmark by more than 700%, generates an alpha that exceeds
13%, and consistently generates forecasts that beat the benchmark more than 60% of the time over
the past 24 years.

Authors

• Jack Strauss, University of Denver

• Philipp Schaberl, University of Denver