Financial Distress and the Value Premium

The value premium is the empirical observation that low market/book “value” stocks have higher returns than high market/book “growth” stocks. In this paper, we report evidence that there is a value premium for firms in financial distress despite the anomalous observation that firms in financial distress have low returns and low values. We argue that profitability moderates distress-risk but increases growth-leverage and, thus, we test for a U-shaped relation between returns and profitability from these offsetting forces. We also find a hill-shaped relation between market/book and profitability. A U-shaped relation between returns and profitability and a hill-shaped relation between market/book and profitability generates a value premium for firms in financial distress. When market/book is low (high or low profitability), returns are high