Ball et al. (2016): Why Cash-Based Profitability Predicts Stock Returns

#Key Takeaways // Verified link content - Cash-based operating profitability predicts stock returns better than accrual-based measures - Removing accruals from profitability eliminates the "noise" caused by accounting choices - This paper is the primary basis for our profitability factor (30% weight) - The cash profitability premium is roughly 6% per year—the largest of any single factor - Results are robust across market caps, time periods, and international markets

#The Paper at a Glance

Title: Accruals, cash flows, and operating profitability in the cross section of stock returns

Authors: Ray Ball, Joseph Gerakos, Juhani T. Linnainmaa, and Valeri Nikolaev (University of Chicago)

Published: Journal of Financial Economics, 2016

DOI: 10.1016/j.jfineco.2016.03.002

This paper fundamentally changed how quantitative investors measure profitability. Before Ball et al., most models used accounting-based profitability (net income, ROE, or gross profit). Ball and his co-authors showed that stripping out accruals—the non-cash components of earnings—creates a far more powerful return predictor.

#What the Paper Found

The Problem with Accrual-Based Profitability

Traditional profitability measures include "accruals"—revenue recognized but not yet collected, expenses recorded but not yet paid, depreciation schedules, and other accounting adjustments.

Accruals are subject to: - Management discretion (earnings management) - Estimation errors (bad debt provisions, inventory write-downs) - Accounting rule differences across industries

These accruals add noise to profitability measures, weakening their ability to predict future returns.

The Solution: Cash-Based Profitability

Ball et al. proposed measuring profitability using only the cash components:

The cash-based measure nearly doubles the return spread compared to traditional accrual profitability.

Why Cash Profitability Works Better

1. 1Accruals tend to reverse. Companies with high accruals today often see earnings decline tomorrow as those accruals unwind.
2. 2Cash is harder to manipulate. You either have the cash or you don't.
3. 3Cash profitability captures sustainable earnings. It filters out temporary accounting boosts.

#Key Results

The paper tested profitability measures across the full CRSP/Compustat universe from 1963-2013:

The spread is economically large and statistically significant (t-statistic > 4.0), well above the Harvey et al. (2016) threshold of 3.0 for avoiding data-mining concerns.

#Why This Paper Matters for Investors

1. It Solved the Profitability Puzzle

Before this paper, researchers debated which profitability measure to use. Novy-Marx (2013) advocated gross profitability. Fama and French (2015) used operating profitability. Ball et al. showed cash-based operating profitability dominates all other measures.

2. It Explains the Accrual Anomaly

The well-known "accrual anomaly" (Sloan, 1996)—where companies with low accruals outperform—is largely subsumed by cash-based profitability. The two effects are really measuring the same thing: investors should focus on cash earnings, not accounting earnings.

3. It's Practically Useful

Unlike some academic findings that disappear after transaction costs, the cash profitability premium is large enough to survive real-world implementation.

#How This Applies to Our Rankings

This paper is the foundation of our profitability factor, which carries the highest weight in our model at 30%.

We calculate cash-based operating profitability following Ball et al.'s methodology:

1. 1Start with revenue
2. 2Subtract cost of goods sold and SGA expenses
3. 3Add back R&D (it's an investment, not a true cost)
4. 4Adjust for changes in accruals
5. 5Divide by total assets

Stocks with the highest cash profitability receive the best profitability scores, which heavily influence their overall composite ranking.

The 30% weight reflects the academic evidence: cash profitability is the most consistent, robust factor across market conditions and time periods.

See our full methodology →

#Academic Source

Ball, R., Gerakos, J., Linnainmaa, J. T., & Nikolaev, V. (2016). "Accruals, cash flows, and operating profitability in the cross section of stock returns." Journal of Financial Economics, 121(1), 28-45.