Working Paper: CEPR ID: DP17251
Authors: Francesco Franzoni; Daniel Obrycki; Rafael Resendes
Abstract: In the asset pricing literature, higher investment is associated with lower expected stock returns. On the other hand, practitioners view investment as a value-creating activity when it generates payoffs above the cost of capital. The paper reconciles these views. Starting from a discounted cash-flow tautology, we argue that expected returns correlate positively with expected investment whenever the return on equity is large enough. We label this prediction the wealth creation effect. The empirical evidence supports this channel. The interaction of profitability and investment positively correlates with stock returns controlling for the usual characteristics. A wealth creation factor earns a premium of about 24bps per month leading to sizeable Sharpe ratio improvements relative to popular factor models.
Keywords: profitability factor; investment factor; asset pricing; net present value; wealth creation
JEL Codes: G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Higher Investment (G31) | Enhanced Firm Value (G32) |
| Interaction of profitability and investment (G31) | Stock Returns (G12) |
| Profitability and investment (G31) | Wealth Creation Effect (E21) |
| Firms investing profitably (G31) | Higher future cash flows (G19) |
| Interaction of profitability and investment (G31) | Future Earnings Growth (O49) |