Inside Out: Decomposing Profitability and the Cross-Section of Stock Returns

Asset turnover, an inside component of profitability in the Dupont analysis, has an ability to predict average stock returns. In the portfolio sort, firms with high asset turnover earn high expected returns, which is unexplained by risk-adjusted asset pricing models. In the cross-section, asset turnover effect persists after adjusting for size, book-to-market, momentum, asset growth, and profitability. In contrast, profit margin, the other component of profitability in the Dupont analysis, has no predicting power of stock returns. Our evidence indicates that asset turnover is the main driver of the observed profitability premium (Novy-Marx (2013) and Ball, Gerakos, Linnainmaa, and Nikolaev (2015)).