Agency Problem and Stock Returns: Combining Measures of Asset Growth and Gross Profit

In this paper, we propose a new factor in predicting stock returns, after taking agency problems into account. Although intensive studies have focused on asset growth and profitability as factors in predicting future returns, very limited attention has been given to their interaction. We construct a measure that combines both asset growth and scaled gross profit in a single measure (defined as AGGP, hereafter), by excluding the change in capital expenditures from gross profit. We demonstrate that our measure of profitability controls for the agency problem from managerial decisions in investment. Our results are also robust to the scaling issues raised by recent studies. Further, consistent with prior literature, our measure produces superior results in the full universe of CRSP stocks, but inferior results when applied to a subset of the 500 largest nonfinancial firms. This is consistent with the fact that those largest firms are less affected by the agency problem, leading to the failure of our new measure in predicting future returns among this subsample. In sum, our new measure sheds new lights on how to price agency issues, by providing a “cleaner” profitability measure free of agency costs and also lending supportive evidence to the mispricing explanation of the asset-growth effect.