Growth Options and Firm Valuation

SAFE Working Paper No. 6

40 Pages Posted: 27 Feb 2013 Last revised: 17 Apr 2017

See all articles by Holger Kraft

Holger Kraft

Goethe University Frankfurt

Eduardo S. Schwartz

University of California, Los Angeles (UCLA) - Finance Area; Simon Fraser University (SFU); National Bureau of Economic Research (NBER)

Farina Weiss

Goethe University Frankfurt

Multiple version iconThere are 4 versions of this paper

Date Written: April 12, 2017

Abstract

This paper studies the relation between firm value and a firm's growth options. We find strong empirical evidence that (average) Tobin's Q increases with firm-level volatility. The significance mainly comes from R&D firms, which have more growth options than non-R&D firms. By decomposing firm-level volatility into its systematic and unsystematic part, we document that only idiosyncratic volatility has a significant effect on valuation. Second, we analyze the relation of stock returns to realized contemporaneous idiosyncratic volatility and R&D expenses. Single sorting on idiosyncratic volatility yields a significant negative relation between portfolio alphas and contemporaneous idiosyncratic volatility for non-R&D portfolios, whereas in a four-factor model the portfolio alphas of R&D portfolios are all positive. Double sorting on idiosyncratic volatility and R&D expenses also reveals these differences between R&D and non-R&D firms. To control for several explanatory variables simultaneously, we also run panel regressions of firm-level alphas which confirm the relative importance of idiosyncratic volatility that is amplified by R&D expenses. Finally, we show that our results are robust to the definition of idiosyncratic volatility. We tease out the ``true'' idiosyncratic volatilities by performing a principal-component analysis on the residuals of Fama-French regressions and find that our main results still hold for this alternative definition of idiosyncratic volatility.

Keywords: Firm valuation, Real options, Volatility, R&D expenses, PCA

JEL Classification: G12

Suggested Citation

Kraft, Holger and Schwartz, Eduardo S. and Schwartz, Eduardo S. and Weiss, Farina, Growth Options and Firm Valuation (April 12, 2017). SAFE Working Paper No. 6, Available at SSRN: https://ssrn.com/abstract=2224014 or http://dx.doi.org/10.2139/ssrn.2224014

Holger Kraft (Contact Author)

Goethe University Frankfurt ( email )

Faculty of Economics and Business
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

Eduardo S. Schwartz

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-1953 (Phone)
310-206-5455 (Fax)

Simon Fraser University (SFU) ( email )

8888 University Drive
Burnaby, British Columbia V5A 1S6
Canada

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Farina Weiss

Goethe University Frankfurt ( email )

Faculty of Economics and Business
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

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