Does the Market Correctly Value Investment Options?

Abstract

This paper shows that the stock market misprices firms' investment options. We build a real options model of optimal investment under uncertainty to estimate the value of firms' investment options. We show that firms with valuable investment options have a higher likelihood of being mispriced. Importantly, this mispricing is not one-sided, as such firms are equally likely to be undervalued or overvalued. Our paper adds to the debate on whether public equity markets are myopic and systematically undervalue innovative firms. We show that this is not necessarily the case.

Keywords: Misvaluation, Investment Options, Optimal Investment, Demand Uncertainty, Future Returns, Structural Estimation

JEL Classification: G14, G32