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Growth Options and Firm Valuation

European Financial Management, Vol. 24, Issue 2, pp. 209-238

Authors:
Holger Kraft,
Eduardo S. Schwartz
Research Area:
Financial Markets
Date:
Mar 2018
Keywords:
Firm valuation, Real options, Volatility, R&D expenses
Abstract:

This paper studies the relationship between firm value and a firm's growth options. We find strong empirical evidence that 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. Sorting on idiosyncratic volatility yields a significant negative relationship between portfolio alphas and contemporaneous idiosyncratic volatility for non-R&D portfolios.

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