Exploiting ergodicity in forecasts of corporate profitability Philipp Mundt, Simone Alfarano and Mishael Milakovic Working Paper No. 147 March 2019 b B A M BAMBERG E CONOMIC RESEARCH GROUP 0 k* k BERG Working Paper Series Bamberg Economic Research Group Bamberg University Feldkirchenstraße 21 D-96052 Bamberg Telefax: (0951) 863 5547 Telephone: (0951) 863 2687
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[email protected] Exploiting ergodicity in forecasts of corporate profitability∗ Philipp Mundty Simone Alfaranoz Mishael Milaković§ Abstract Theory suggests that competition tends to equalize profit rates through the pro- cess of capital reallocation, and numerous studies have confirmed that profit rates are indeed persistent and mean-reverting. Recent empirical evidence further shows that fluctuations in the profitability of surviving corporations are well approximated by a stationary Laplace distribution. Here we show that a parsimonious diffusion process of corporate profitability that accounts for all three features of the data achieves better out-of-sample forecasting performance across different time horizons than previously suggested time series and panel data models. As a consequence of replicating the empirical distribution of profit rate fluctuations, the model prescribes a particular strength or speed for the mean-reversion of all profit rates, which leads to superior forecasts of individual time series when we exploit information from the cross-sectional collection of firms. The new model should appeal to managers, an- alysts, investors and other groups of corporate stakeholders who are interested in accurate forecasts of profitability.