The Value and Profitability Premiums

Abstract

We present a unified risk-based explanation for the value premium and the prof-itability premium as well as for their inverse relationship in the time series. Our simple equity valuation model takes into account financial leverage and time-varying credit conditions explicitly and allows for potential shareholder recovery upon the resolu-tion of financial distress. The model predicts that the value premium declines and the profitability premium is prominent when credit spreads increase under tightening credit conditions, while the opposite happens when credit spreads decrease, resulting in their inverse relationship in the time series. The model further predicts that the sensitivity of the value and profitability premiums to credit conditions depends on the degree of potential shareholder recovery. Our empirical evidence strongly supports these predictions.