Deflating profitability

Gross profit scaled by book value of total assets predicts the cross section of average returns. Novy-Marx (2013) concludes that it outperforms other measures of profitability such as bottom line net income, cash flows, and dividends. One potential explanation for the measure׳s predictive ability is that its numerator (gross profit) is a cleaner measure of economic profitability. An alternative explanation lies in the measure׳s deflator. We find that net income equals gross profit in predictive power when they have consistent deflators. Deflating profit by the book value of total assets results in a variable that is the product of profitability and the ratio of the market value of equity to the book value of total assets, which is priced. We then construct an alternative measure of profitability, operating profitability, which better matches current expenses with current revenue. This measure exhibits a far stronger link with expected returns than either net income or gross profit. It predicts returns as far as ten years ahead, seemingly inconsistent with irrational pricing explanations.