Return Predictability and Shareholders' Real Options

42 Pages Posted: 27 Jan 2009 Last revised: 20 Apr 2009

See all articles by Lee-Seok Hwang

Lee-Seok Hwang

Seoul National University - College of Business Administration

Byungcherl Charlie Sohn

University of Macau - Department of Accounting and Information Management

Date Written: January 27, 2009

Abstract

This study re-interprets the properties of the residual income model by highlighting the shareholders' abandonment (liquidation or adaptation) option. We estimate the value of this real option as an explicit component of abnormal earnings in the residual income model and test the improvement in valuation after incorporating it into the model. Relative to the traditional specification of the residual income model, this real options model has a stronger predictive power for future abnormal stock returns. We also find that the superior return predictability of the real options model is pronounced in the set of firms with a high probability of exercising liquidation options (e.g., those with low profitability, low growth opportunities, high underlying asset volatility, and low intangible assets), which is consistent with the importance of shareholders' abandonment option in equity valuation. The results are robust to extensive sensitivity checks.

Keywords: Abandonment (liquidation or adaptation) option, Residual income model, Abnormal earnings, Real options model, Return predictability

JEL Classification: G12, M41

Suggested Citation

Hwang, Lee-Seok and Sohn, Byungcherl Charlie, Return Predictability and Shareholders' Real Options (January 27, 2009). Review of Accounting Studies, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1333565

Lee-Seok Hwang

Seoul National University - College of Business Administration ( email )

Seoul, 151-742
Korea, Republic of (South Korea)

Byungcherl Charlie Sohn (Contact Author)

University of Macau - Department of Accounting and Information Management ( email )

Ave. Padre Tomas Pereira
Taipa
Macau
China

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