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In the world of stock market investing, hype and marketing play a big role in driving up the prices of stocks. At the end of the day, however, a company’s ability to yield a profit on the stock exchange comes down to its long-term survival – and, since a lot of attention is given to profitability, it’s no surprise that this area is the focus of intense research.

For a long time, the market has relied on investment theories such as the capital asset pricing model (CAPM) in assessing profitability. One of the core aims of CAPM is to illustrate the relationship between risk and return. Specifically, this model highlights the tenet that the higher the risk associated with an investment, the higher the potential for good returns.

While the CAPM model has a firm theoretical foundation suitable for teaching graduate students in business and finance, many have raised the need for empirical data to back up the theory. This was the topic of discussion at an Accounting Symposium held at Singapore Management University (SMU) School of Accounting and Research (SOAR) in December 2017. The keynote speaker was Professor John E. Core, who is a Professor of Accounting at the Massachusetts Institute of Technology’s Sloan School of Management.

Joey Horn, the Managing Director at Oak Management AS in Oslo, Norway, was a guest lecturer at the institution in the fall semesters of 2009 and 2010, where she co-taught an elective Master of Business Administration (MBA) course on Strategy.

Explaining Profitability

The capital asset pricing model was developed by Harry Markowitz in 1952 and later adopted by investors and economists. The CAPM theory illustrates that the return of a particular investment is equal to the rate on security that is risk-free plus a risk premium. If the investment doesn’t meet or exceed the return required, then it shouldn’t be considered.

According to the CAPM theory, the only reason why an investor should gain more returns by investing in a specific stock over another is based on the stock’s market risk factor. CAPM is widely used in financial theory but has raised doubts over its applicability in real life.

The big sticking point with many critics is the risk factor, and this has led to counter theories that seek to improve the accuracy of CAPM. One of these is the Fama and French Three-Factor Model that introduces more factors for consideration: size risk and value risk. This model takes into consideration that small-cap and value stocks typically outperform markets, and so by including them, they make it better to evaluate a fund manager’s performance.

Researcher Kenneth French and Nobel Laureate Eugene Fama are credited with coming up with the Fama and French model, which they developed through research on how to improve the measurement of market returns. Following further research, the two have extended the model to incorporate two more factors – investment and profitability – to make it a five-factor model. Based on this development, the model predicts that firms with higher profits are more likely to realise higher returns in the stock market.

Another financial model that has been adopted for explaining profitability is the implied cost of capital (ICC) model. While it has similarities to the Fama and French model, the ICC model is lauded for its strong theoretical foundation due to its use of the discounted cash flow valuation technique. However, it’s main limitation is that its calculations are based on forecasts that can be biased according to the financial analyst coming up with them.

According to researchers, the biggest takeaway in this discussion is that if users are to use factor models to predict profitability, they should use multiple approaches to demonstrate it since each methodology has its trade-offs.