Return Predictability and the Real Option Value of Segments

Posted: 17 Aug 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: August 15, 2017

Abstract

Theory suggests that firm value should include the value of real options; that is, firms have the option to expand more profitable businesses and liquidate less profitable businesses. In a diversified firm, each segment has its own real options. Applying real options theory to a diversified firm at the firm level neglects the value of segment-level options. If investors overlook segment-level options, mispricing will occur. Using data from 1981 to 2013, we find that a hedge portfolio buying diversified firms in the highest decile of the estimated real option value of segments (RVS) and selling those in the lowest RVS decile earns a significant 0.79% size-adjusted monthly return. The hedge returns are more significant for firms whose growth opportunities mainly lie in the more profitable segments. We also find that the predictive power of RVS is stronger for firms with high growth, lower analyst coverage, and stronger corporate governance. Further investigation links improved operating performance to the exercise of segment-level real options.

Keywords: Real option 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 Option Value of Segments (August 15, 2017). Review of Accounting Studies, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3019810

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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