Working Paper: NBER ID: w31068
Authors: Ravi Jagannathan; Robert Korajczyk; Kai Wang
Abstract: We treat expenditures that create intangible assets as investments and instead of expensing them, we add them back to earnings when measuring the return on equity of firms while constructing the profitability factor in the Fama and French (2015) five factor model. The profitability factor we construct has significant alpha relative to many extant multi-factor asset-pricing models, including the standard Fama-French five factor model. When the profitability factor in the Fama and French (2015) five factor model is replaced with our intangibles adjusted profitability factor, the model performs better in explaining the cross section of stock returns, and several anomalies documented in the literature. Portfolios that exploit price momentum, earnings momentum, and operating leverage no longer have significant alphas. The improvement is consistent with the dividend discount model for equity valuation. Adjusted earnings constructed by treating expenditures that create intangible assets as investments help forecast the cross section of future cash dividends and operating cash flows on stocks better, especially at longer horizons. Adopting our adjustment when constructing the monthly rebalanced profitability factor in the Hou et al. (2015) four factor model improves its performance as well. Our intangible adjusted profitability factor has smaller left tail risk and co-tail risk with the market when compared to the standard profitability factor.
Keywords: No keywords provided
JEL Codes: G0; G1; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| intangible expenditures treated as investments (E22) | intangibles-adjusted profitability factor (G31) |
| intangibles-adjusted profitability factor (G31) | improved model performance (C52) |
| intangibles-adjusted profitability factor (G31) | significant alpha compared to original profitability factor (E25) |
| intangibles-adjusted profitability factor (G31) | better forecasting of future cash flows (G17) |
| intangibles-adjusted profitability factor (G31) | higher R-squared values in regressions (C29) |
| treatment of intangible expenditures (H54) | enhanced predictive power (C52) |