Do Accruals Adjustments Help Capture the Profitability Premium?
Rigorous research on what drives stock and bond returns has been part of Dimensional’s DNA since day one. A profound understanding of what drives differences in expected returns allows us to provide our clients with robust, value-added investment solutions that pursue higher expected returns in a systematic and cost-efficient manner.
Dimensional’s work on the profitability premium shows that measures of current profitability contain reliable information about future profitability and, consequently, about expected returns.1 Our research identifies operating profitability—defined as operating income before depreciation and amortization minus interest expense, scaled by book equity—as a comprehensive measure of profitability that captures major business expenses and revenues across various sectors. We use this measure of profitability to target the profitability premium across our equity strategies.
Some researchers have argued that profitability measures should discriminate between different types of earnings. Proponents of cash profitability measures believe accruals should be subtracted from operating profits, as these components of earnings have been negatively related to future stock returns. Our latest study takes a deeper look at accruals and cash profitability to see whether this adjustment offers a more reliable way to capture the profitability premium.
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Robert J. Pyle, CFP®, CFA is president of Diversified Asset Management, Inc. (DAMI). DAMI is licensed as an investment adviser with the State of Colorado Division of Securities, and its investment advisory representatives are licensed by the State of Colorado. DAMI will only transact business in other states to the extent DAMI has made the requisite notice filings or obtained the necessary licensing in such state. No follow up or individualized responses to persons in other jurisdictions that involve either rendering or attempting to render personalized investment advice for compensation will be made absent compliance with applicable legal requirements, or an applicable exemption or exclusion. It does not constitute investment or tax advice. To contact Robert, call 303-440-2906 or e-mail info@diversifiedassetmanagement.com.
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