Scholars and investors have studied the value premium for several decades. However, the debate over whether risk factors or biased market participants cause the value premium has never been settled. The risk explanation argues that value firms are fundamentally riskier than growth firms. At the same time, the behavioral explanation argues that biased market participants systematically misprice value and growth stocks. In this paper, I use the implied cost of equity capital to capture all risks that investors demand a premium and sort stocks into risk quantiles. The implied cost of equity capital is estimated using models proposed by Gebhardt et al., Claus and Thomas, Ohlson and Juettner-Nauroth, and Easton. I find that value stocks have higher implied cost of equity capital and lower forecasted earnings growth while growth stocks have lower implied cost of equity capital and higher forecasted earnings growth. More importantly, even within the same risk quantile, the value premium still exists. The results suggest that risk and behavioral factors simultaneously cause the value premium. Furthermore, by decomposing the holding period return, I find that adjustments in valuation ratios caused by negative earnings surprises for growth firms and positive earnings surprises for value firms at least partially lead to the value premium.

In this research, I classify all stocks into two groups: dividend and non-dividend payers and hypothesize that profitability premium may only exist among the firms with unforeseeable future cash flows, i.e., non-dividend payers. As expected, my empirical results support that profitability premium only exists among non-dividend payers but is very trivial among dividend payers. Dividends have a moderate effect on profitability premiums. To dig further into the source of profitability premium, I investigated risk and behavioral explanations from three perspectives: macroeconomics, industry, and total risks investors perceive for a firm. The evidence from empirical analysis supports that the profitability premium is mainly driven by the overpriced, unprofitable non-dividend payers, which, on average, have negative earnings announcement returns. In contrast, there is no significant positive or negative abnormal return from earnings announcements for portfolios sorted by profitability among dividend payers. Furthermore, the evidence from analyst forecast errors confirms that analysts are over-optimistic about unprofitable non-dividend-paying stocks and disagree more with their EPS forecast. Overall, the study finds that investors' expectation errors are the source of the profitability premium. It rejects the idea that risk is the profitability premium driver.