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The endogeneity of profitability and investment

Author

Listed:
  • Peter Chinloy

    (Quant Advisors)

  • Matthew Imes

    (Stetson University)

Abstract

In academic research, stock returns are frequently regressed on financial variables such as profitability, value, and investment. Managers, who are incentivized through equity compensation, may make decisions which affect financial variables. If such decisions are endogenous, statistical significance in the financial variable coefficient estimates may stem from correlation rather than causation. This study presents a causality framework between U.S. firm decisions and stock returns. A set of instruments is first correlated with stock returns. When fitted values predict returns, there is a confirmed anomaly. Fitted values then replace profitability, investment, and investment growth. Return significance falls by more than half for profitability and investment, while its predicted growth is insignificant. Vector autoregressions and graphic analysis confirm the flow of causality from predicted profitability and investment to stock returns.

Suggested Citation

  • Peter Chinloy & Matthew Imes, 2025. "The endogeneity of profitability and investment," Review of Quantitative Finance and Accounting, Springer, vol. 65(2), pages 691-726, August.
    • Handle: RePEc:kap:rqfnac:v:65:y:2025:i:2:d:10.1007_s11156-024-01357-2
    DOI: 10.1007/s11156-024-01357-2
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    Keywords

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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • C36 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Instrumental Variables (IV) Estimation

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