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Uncertainty and Valuations

41 Pages Posted: 23 Mar 2009 Last revised: 6 Sep 2012

Martijn Cremers

University of Notre Dame

Hongjun Yan

Driehaus College of Business, DePaul University

Date Written: September 5, 2012

Abstract

The idea that uncertainty about a firm’s profitability could increase its stock valuation has been proposed by Pastor and Veronesi (2003) to explain several phenomena in financial markets. We further examine this idea in a setup with both stocks and bonds, and show that unless a firm is deeply in debt, the same logic implies that uncertainty increases its stock valuation but decreases its bond valuation, and that the 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. Our evidence based on some (but not all) proxies supports the positive association between stock valuation and uncertainty. However, our evidence generally does not support the negative association between uncertainty and bond valuations using existing uncertainty proxies, particularly firm age. These results challenge the interpretation of the existing uncertainty proxies and thus the results in the literature employing them.

Keywords: Uncertainty, convexity, valuation, technology bubble

JEL Classification: G12

Suggested Citation

Cremers, Martijn and Yan, Hongjun, Uncertainty and Valuations (September 5, 2012). Yale ICF Working Paper No. 09-06. Available at SSRN: https://ssrn.com/abstract=1364367 or http://dx.doi.org/10.2139/ssrn.1364367

K. J. Martijn Cremers

University of Notre Dame ( email )

P.O. Box 399
Notre Dame, IN 46556-0399
United States

Hongjun Yan (Contact Author)

Driehaus College of Business, DePaul University ( email )

1 East Jackson Blvd.
Chicago, IL 60604
United States

HOME PAGE: http://sites.google.com/site/hongjunyanhomepage/

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