The endogeneity of profitability and investment

Peter Chinloy () and Matthew Imes ()
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Peter Chinloy: Quant Advisors
Matthew Imes: Stetson University

Review of Quantitative Finance and Accounting, 2025, vol. 65, issue 2, No 7, 726 pages

Abstract: 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.

Keywords: Stock returns; Endogeneity; Investment; Profitability (search for similar items in EconPapers)
JEL-codes: C36 G12 G31 (search for similar items in EconPapers)
Date: 2025
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DOI: 10.1007/s11156-024-01357-2

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