Abstract In this paper, we propose and empirically test a cross‐sectional profitability forecasting model which incorporates two major improvements relative to extant models. First, in terms of model construction, we incorporate mean reversion through the use of a two‐stage partial adjustment model and inclusion of a number of additional relevant determinants of profitability. Second, in terms of model estimation, we employ least absolute deviation (LAD) analysis instead of ordinary least squares because the former approach is able to better accommodate outliers. Results reveal that forecasts from our model are more accurate than three extant models at every forecast horizon considered and more accurate than consensus analyst forecasts at forecast horizons of two through five years. Further analysis reveals that LAD estimation provides the greatest incremental accuracy improvement followed by the inclusion of income subcomponents as predictor variables, and implementation of the two‐stage partial adjustment model. In terms of economic relevance, we find that forecasts from our model are informative about future returns, incremental to forecasts from other models, analysts’ forecasts, and standard risk factors. Overall, our results are important because they document the increased accuracy and economic relevance of a cross‐sectional profitability forecasting model which incorporates improvements to extant models in terms of model construction and estimation.

ABSTRACT We provide evidence about allocations of cash flow freed up by not paying taxes (“tax-related cash”). Uncertainty about future repayments suggests firms may use tax-related cash more cautiously than other cash flow. We utilize a flow-of-funds model from finance to quantify the relative amounts of tax-related cash associated with various potential uses of operating cash flow. We find firms allocate tax-related cash differently than other after-tax cash flow. Prior studies find tax avoiders hold more cash, and our results suggest this is because firms invest less (and save more) tax-related cash. We also find that the allocation of tax-related cash varies with relative financial constraints, economic uncertainty, and firms' multinational status in ways consistent with prior findings. For example, firms facing relatively higher levels of financial constraints invest a lower (higher) percentage of tax-related cash in capital expenditures (marketable securities and R&D), possibly to preserve funds for future investment opportunities. JEL Classifications: G31; H20.