Investment Uncertainty And Stock Returns

This paper theoretically investigates the effect of uncertainty about future investment on expected stock returns. Based on a real options framework, we incorporate the learning-by-doing effect to analyze the irreversible investment problem. In our investment decision framework, the timing of expansion is endogenous and results from a value-maximizing decision. In addition, there are two important implications of our framework. First, we show that an increase in the relative valuation ratio, as measured by the book-to-market ratio, raises average stock returns. This positive relationship helps to explain the value premium. Second, we investigate how uncertainty about investment affects expected stock returns. Based on the closed-form solution in our framework, we suggest that less uncertainty about investment induces lower expected stock returns.