DP17251 The Wealth Creation Effect in Stock Returns

Author(s): Francesco Franzoni, Daniel Obrycki, Rafael Resendes
Publication Date: April 2022
Keyword(s): Asset Pricing, Investment Factor, Net-Present Value, Profitability factor, Wealth Creation
JEL(s): G11, G12
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=17251

In the asset pricing literature, higher investment is associated with lower expected stock returns. On the other hand, practitioners view investment as a value-creating activity when it generates payoffs above the cost of capital. The paper reconciles these views. Starting from a discounted cash-flow tautology, we argue that expected returns correlate positively with expected investment whenever the return on equity is large enough. We label this prediction the wealth creation effect. The empirical evidence supports this channel. The interaction of profitability and investment positively correlates with stock returns controlling for the usual characteristics. A wealth creation factor earns a premium of about 24bps per month leading to sizeable Sharpe ratio improvements relative to popular factor models.