Q&A on Profit Growth and Expected Returns

As Dimensional shares new research on profit growth and is starting to incorporate profit growth systematically across its equity strategies, we sat down with the Co-Heads of Strategy Research, Namiko Saito and Stanley Black, to find out more about the new research and its investment implications.

Namiko Saito: We are always looking for ways to improve our strategies, whether by identifying new sources of information or improving the use of existing sources of information.

Profit growth is a little bit of both. It is a new variable in our investment process, but it will supplement a variable we already use, current profitability, in helping us better capture expected future profitability and target the profitability premium.

Our interest in this topic is grounded in valuation theory, which links expected returns to the price investors pay today and the cash flows they expect to get in the future. Hence, all else equal, companies with higher expected profitability should have higher expected returns. In the 2010s, we conducted extensive research on profitability and showed that current profitability, especially operating profitability, helps predict expected future profitability and stock returns. Based on this research, our equity strategies began systematically emphasizing companies with higher current profitability. Of course, expected future profitability is driven not only by current profitability but also by expected future profit growth, so we started looking into whether we could find a strong proxy for expected future profit growth.

In addition, there is an intuitive economic rationale for why a company with higher profit growth should have higher expected returns. If you just booked higher growth in profits relative to peers, you naturally stand out in the industry. Your competitors might start mimicking your innovation or product that drove that growth, creating a challenging competitive landscape. This introduces higher uncertainty about whether you can sustain that newly established level of profitability. Investors may demand higher expected returns as compensation for bearing that risk to the extent it is systematic and not diversifiable.

Indeed, it was this connection to both valuation theory and an intuitive economic rationale that got us excited about testing the idea with data.

Stanley Black: There were three steps to our tests. The first was to test whether a firm’s current profit growth is a reliable predictor of its future profit growth. Using a standard regression approach, we found that this is indeed the case. Differences in current profit growth across firms can help predict differences in profit growth up to three quarters into the future in the US, developed ex US, and emerging markets.

In the second step, we looked at whether that short-term predictive power for future profit growth was enough to provide forecasting power for a firm’s future profitability. Using a similar regression approach, we found that this was again the case across all three regions, even after controlling for firm characteristics like current profitability. 

The third and final step was to test whether a firm’s current profit growth could predict its future returns one month out, controlling for other firm characteristics that we already know are related to returns (size, relative price, profitability, momentum, etc). Again, using firm-level regressions, we found that profit growth was a strong predictor of future returns. Moreover, sorts on profit growth generate large and reliable spreads in average next-month returns across different regions.¹

Stan: Not necessarily. We view profit growth less as a standalone return premium and more as information that helps us form better expectations about future profitability. The key insight is that expected returns are driven by expectations about future cash flows, and profit growth sheds light on those expectations.

Namiko: One interesting finding is the relation between profit growth and price momentum, one of the most widely studied return patterns in finance.

Profit growth and momentum appear to complement each other. Profit growth gives us a cleaner signal about future profit growth, but it is updated only when new financial statements are released. Price momentum is a noisier signal, but it is updated continuously.

What’s especially interesting is how this relation connects back to valuation theory. Both profit growth and price momentum tell us something about a company’s near-term profit prospects and, therefore, its expected future cash flows. This link suggests a valuation-based perspective on why price momentum predicts returns and why its predictive power is relatively short-lived.

Stan: Since current profit growth improves our predictions of future profitability, it is natural that in our implementation we would seek to pair our current profitability metric with recent profit growth to enhance our prediction of future profitability and hence expected returns. One advantage of this approach is that we can incorporate profit growth in all strategies that already target the profitability premium—consistent with the observation that the profit growth effect is prevalent broadly across regions as well as the size, value, and profitability segments. In addition, our research found a monotonic relation between profit growth and returns. As a result, we intend to implement broadly across the full spectrum of profit growth.  

Finally, since profit growth is a relatively short-term effect, we need to balance the improvement in expected returns against potential increases in turnover and trading costs. So with this in mind, our implementation approach combines current profitability with profit growth to form a more powerful proxy for future profitability.

Namiko: While many strategies incorporate growth-related measures, what distinguishes our approach is how we select and use those measures.

We start with an economic framework grounded in valuation theory, which links expected returns to expected future cash flows. That leads us to consider two complementary signals for future profitability: where a company’s profitability stands today and how it has grown recently. Both help us form better expectations about future profitability and returns.

The next step is how we measure that growth. Our research shows that the year-on-year change in quarterly operating profits, scaled by book equity, is particularly informative. This measure focuses on recent growth, which is important given our empirical finding that profit growth tends to persist over relatively short horizons. On the other hand, annual or multiyear growth measures such as five-year sales growth or year-on-year earnings-per-share growth combine recent with older information, potentially diluting the predictive power, since over longer horizons, we observe profitability tends to revert to the market average.

So the distinction isn’t simply that we incorporate profit growth. It is that we combine a theoretical framework with empirical testing to determine which measures are most informative. By letting both theory and evidence guide implementation, we believe we can make more reliable investment decisions in the presence of noisy financial data.

Stan: We started our research by examining four proxies of future profit growth: SUE, CAR, price momentum, and profit growth. We found that recent profit growth is the strongest predictor, followed by price momentum. We also found that price momentum does complement profit growth in forecasting short-term profit growth, profitability, and returns. However, blending profit growth and price momentum in buy and sell considerations does not appear to add value relative to just considering price momentum. In contrast, adjusting the profitability measure for recent profit growth results in a meaningful improvement in the strategies studied without a material increase in observed turnover. And as already mentioned, this implementation approach nicely aligns with the valuation framework.

Stan: Valuation theory tells us that expected returns depend on expected future cash flows. Our research shows that recent profit growth contains useful information about those future cash flows and helps explain differences in expected profitability and expected returns.

Namiko: More broadly, our results help connect valuation theory, profitability, profit growth, and momentum within a unified framework.