Earnings and Equity Valuation in the Biotech Industry: Theory and Evidence

45 Pages Posted: 23 May 2007

See all articles by Philip Joos

Philip Joos

Tilburg University; TIAS School for Business and Society

Alexei Zhdanov

Pennsylvania State University

Date Written: May 20, 2007

Abstract

This study examines how the price-earnings relation varies with the uncertainty about and the quality of a firm's investments. We develop a real option valuation framework to capture optimal investment and abandonment options in a research-intensive emerging technology, the biotechnology industry. Both management and investors resolve uncertainty about the firm quality over the life cycle from observing past investment successes and failures. We predict that the price-earnings relation is V-shaped and changes over the firm life cycle. Also, as investors learn about the quality of the firm over time, they will value accounting losses and profits more in higher quality firms. Our empirical findings are based on a sample of 301 biotechnology firms with an IPO between 1980 and 2000, and are generally consistent with our predictions. We contribute in several ways to the existing price-earnings literature. First, we provide a theoretical framework for the significant negative price-earnings relation for loss firms. Second, we show how the price-earnings relation changes over time as investors learn about the quality of the firm. Third, we provide a real option valuation model that is better suited for valuing option-intensive firms than the more traditional DCF based models. In addition, we show how nonfinancial information affects the pricing of earnings.

Keywords: real options, research and development

JEL Classification: G12, G31, M41

Suggested Citation

Joos, Philip and Zhdanov, Alexei, Earnings and Equity Valuation in the Biotech Industry: Theory and Evidence (May 20, 2007). Available at SSRN: https://ssrn.com/abstract=987924 or http://dx.doi.org/10.2139/ssrn.987924

Philip Joos (Contact Author)

Tilburg University ( email )

School of Economics and Management
Warandelaan 2
Tilburg, 5000 LE
Netherlands
31 13 4668716 (Phone)
31 13 4668001 (Fax)

HOME PAGE: http://https://www.tilburguniversity.edu/staff/philjoos

TIAS School for Business and Society ( email )

Warandelaan 2
TIAS Building
Tilburg, Noord Brabant 5037 AB
Netherlands

Alexei Zhdanov

Pennsylvania State University ( email )

University Park
State College, PA 16802
United States

HOME PAGE: http://www.alexeizhdanov.com

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