Operating vs Gross Profitability

"Profitability" sounds like a single, obvious idea — profitable companies should be safer, higher-quality holdings than unprofitable ones. But the academic literature has two competing definitions, and they don't rank companies the same way. Novy-Marx's original profitability factor uses gross profit (revenue minus cost of goods sold) divided by total assets. Fama and French's five-factor model instead uses operating profit (revenue minus cost of goods sold, minus selling/general/administrative expenses, minus interest) divided by book equity. Same underlying idea — profitable firms outperform — different line on the income statement, different denominator, and meaningfully different factor.

Why the choice moves the ranking

Cost of goods sold is a relatively "clean" number — mostly the direct cost of making a product. Everything below that line (SG&A, R&D, marketing, interest expense) reflects business-model choices, not just efficiency: a software company spends heavily on R&D and sales, while a utility spends little on either. Novy-Marx argued that gross profit is the cleanest signal of a firm's underlying economic productivity, because subtracting more line items subtracts a firm's discretionary spending decisions along with genuine costs, and discretionary reinvestment shouldn't be punished as unprofitability.

Worked example

A software company has revenue of $500 million and cost of goods sold (mostly hosting and support) of $100 million, giving gross profit of $400 million against $1 billion in assets — a gross profitability of 40%, near the top of the market. It also spends $250 million on R&D and sales, so operating profit is $400 - 250 = 150$, i.e. $150 million, against $600 million book equity — an operating profitability of 25%, solidly mid-pack rather than elite. A traditional manufacturer might show the opposite pattern: modest gross margins but high operating profitability, because it spends little on R&D or marketing relative to its revenue.

What this means in practice

A portfolio built on gross profitability will systematically tilt toward asset-light, R&D-intensive businesses (software, pharma) relative to one built on operating profitability, which favors firms with lean overhead regardless of how they earn their gross margin. Neither is "more correct" — they capture different aspects of quality, and many quantitative quality composites (like QMJ) deliberately blend both rather than picking one.