Misvaluation of Investment Options
68 Pages Posted: 9 Aug 2016 Last revised: 25 Apr 2017
Date Written: April 2017
We study whether investment options are correctly priced. We build a real options model of optimal investment in the presence of demand uncertainty. We structurally estimate the model and classify stocks into undervalued and overvalued based on the difference between observed and model-implied firm values. A long-short strategy that buys undervalued and shorts overvalued stocks generates annualized alphas between 10% and 17%. This relation is only present in subsamples of firms with high proportions of investment options. We interpret these findings as evidence of misvaluation of investment options, leading to mispricing in equity markets that is gradually corrected over time.
Keywords: Misvaluation, Investment Options, Optimal Investment, Demand Uncertainty, Future Returns, Structural Estimation
JEL Classification: G14, G32
Suggested Citation: Suggested Citation