Income statement leverage and expected stock returns

In light of the ongoing debate regarding the classic financial-leverage measures' stock returns predictability power, this study posits a new financial leverage measure –namely, income statement leverage (ISL). Unlike market leverage (ML) and book leverage (BL) measures, ISL is not determined by market prices, thereby alleviating concerns regarding leverage's spurious return predictability, due to a "fad" in prices, which eventually degenerates. We show that ISL's returns predictability remains statistically and economically significant, while simultaneously controlling for B/M, market-capitalization (Size), and past performance. Furthermore, while ML and BL returns predictability becomes insignificant or contradicts the tradeoff theory, ISL remains significant.