Abnormal Profitability and Investment, and Their Links to Return-Earnings Relations

Investments in operating assets are expected to generate future profits. Hence, security prices should reflect changes in investors' expectations about the growth and profitability of such investments. Yet, the accounting literature focuses on the security return-earnings relation without paying much attention to investment. We develop a model formalizing our intuition about the value relevance of investment beyond earnings. We then derive empirical predictions that (1) unexpected investment jointly with the expected abnormal rate of profitability has value implications beyond unexpected earnings, and (2) investment drift jointly with the unexpected abnormal rate of profitability has value implications beyond unexpected earnings. We test the model using 11,403 firm-year observations spanning 19 years. The results provide strong support for the predictions. Further, the interactions between inventory investment and abnormal profitability have more significant value implications than those between plant investment and abnormal profitability