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Growth Options and Firm Valuation

SAFE Working Paper No. 6

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

Holger Kraft

Goethe University Frankfurt

Eduardo S. Schwartz

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

Farina Weiss

Goethe University Frankfurt

Multiple version iconThere are 3 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 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 Administration
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)

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 Administration
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany

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