Return Predictability and the Real Options Value of Segments

56 Pages Posted: 1 Oct 2016 Last revised: 14 Nov 2017

See all articles by Pingui Rao

Pingui Rao

Jinan University - Management School

Heng Yue

Singapore Management University - School of Accountancy

Xin Zhou

XY Investments

Date Written: April 30, 2017

Abstract

The real options theory suggests that firm value should include the value of real options, i.e., a firm has the option to expand a more profitable business and the option to liquidate assets of a less profitable business. For a diversified firm, each segment has similar options. Applying the option-based valuation to a diversified firm only at the firm level neglects the real options value of its segments and leads to mispricing and subsequent abnormal returns. Using data from 1981 to 2013, we find that a hedge portfolio buying diversified firms with the highest decile of real options value of segments (RVS) and selling those with the lowest decile of RVS earns a significant 0.79% size-adjusted monthly returns. We also find that the hedge returns are more significant for firms with high growth, with good corporate governance, or with a lower level of analyst following. Further investigations indicate that firms improve operating performance by exercising their segment-level real options. Finally, we provide an alternative explanation for the well-documented diversification discount.

Keywords: Real Options Value, Return Predictability, Abnormal Returns, Segment

JEL Classification: G12, M41

Suggested Citation

Rao, Pingui and Yue, Heng and Zhou, Xin, Return Predictability and the Real Options Value of Segments (April 30, 2017). Singapore Management University School of Accountancy Research Paper No. 2017-66, Available at SSRN: https://ssrn.com/abstract=2845718 or http://dx.doi.org/10.2139/ssrn.2845718

Pingui Rao

Jinan University - Management School ( email )

No. 601, West Huangpu Road
Guangzhou, Guangdong 510632
China

Heng Yue (Contact Author)

Singapore Management University - School of Accountancy ( email )

60 Stamford Road
Singapore 178900
Singapore

Xin Zhou

XY Investments

China

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