Uncertainty and Valuations

Abstract:     
The idea that uncertainty about a firm’s long-run profitability could increase its stock valuation has been proposed by Pastor and Veronesi (2003) to explain a number of phenomena in financial markets. We further examine this idea by analyzing a simple valuation model for both stocks and bonds, in contrast to the existing studies focusing on stocks only. Unless a firm is deeply in debt, our model implies that uncertainty about a firm’s profitability increases its stock valuation and decreases its bond valuation, where uncertainty’s impact is stronger if the firm’s leverage is higher. Using a number of existing uncertainty proxies in the literature and controlling for volatility, we empirically test these predictions. Consistent with the existing literature, our empirical evidence also supports the positive association of stock valuation and uncertainty for all uncertainty proxies. For only one proxy, our empirical evidence is also broadly consistent with uncertainty being negatively related to bond valuation and more so with greater leverage. However, the results based on all other uncertainty proxies generally (for example firm age) do not show a negative association with bond valuations. These results point to a number directions for further examination.

Keywords: Uncertainty, convexity, valuation, technology bubble

JEL Classifications: G12

Working Paper Series