The disaggregation of profit into operating profit and financial profit is beneficial for return analysis because operating profit appears to have a more significant effect on annual returns. The effect is more pronounced if the persistence of the two forms of profit differs over time. Furthermore, the disaggregation of operating profit into sustainable operating profit and unsustainable operating profit is beneficial for return analysis because the former appears to have more of an effect than the latter does on annual returns.
What’s Inside?
The author separates annual profitability into operating profitability and financing profitability. Annual returns are more affected by operating profitability than by financing profitability. When considering conditional persistence (autocorrelation over the previous eight years), if the persistence between the disaggregated components of operating profitability and financing profitability differs for a firm, then the disaggregation of profit appears to be empirically more useful to that firm. The author further separates operating profit into sustainable and unsustainable. The former has a greater effect on annual return than the latter does. This result implies that the market considers operating profit more than financing profit and sustainable operating profit more than unsustainable operating profit.
How Is This Research Useful to Practitioners?
Because the research uses annual data over a 47-year span (1963–2009), the findings are long-term oriented. Consequently, the research suggests that long-term investors should consider the separation of profit into operating and financing and then further separate operating profit into sustainable and unsustainable.
How Did the Author Conduct This Research?
The pertinent accounting data are annual, so annual return data are necessary for the analysis. The data are from Compustat and CRSP for publicly traded firms from 1963 to 2009. The authors exclude firms in the financial industry and smaller firms, which are defined as those whose book value of equity is less than $10 million. Most of the analysis requires cross-sectional regressions across all of the firms for a given year, which creates approximately 62,000 overall observations (outliers in the upper and lower 1% of the cross-sectional distribution of regression variables are deleted) for the 47-year period. For the persistence analysis, a given firm had to have at least eight years of data.
Abstractor’s Viewpoint
I find the analysis interesting, but I wonder how long it takes for these results to become evident within a given firm’s return. The availability of the data is very limiting in regard to answering this question.