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Return predictability and shareholders’ real options

Author

Listed:
  • Lee-Seok Hwang

    (Seoul National University)

  • Byungcherl Charlie Sohn

    (City University of Hong Kong (CityUHK))

Abstract

This study re-interprets the properties of the residual income model by highlighting the shareholders’ abandonment (liquidation or adaptation) option. We estimate the value of this real option as an explicit component of abnormal earnings in the residual income model and test the improvement in valuation after incorporating it into the model. Relative to the traditional specification of the residual income model, this real options model has a stronger predictive power for future abnormal stock returns. We also find that the superior return predictability of the real options model is pronounced in the set of firms with a high probability of exercising liquidation options (for example, those with low profitability, low growth opportunities, high underlying asset volatility, and low intangible assets), which is consistent with the importance of shareholders’ abandonment option in equity valuation. The results are robust to extensive sensitivity checks.

Suggested Citation

  • Lee-Seok Hwang & Byungcherl Charlie Sohn, 2010. "Return predictability and shareholders’ real options," Review of Accounting Studies, Springer, vol. 15(2), pages 367-402, June.
    • Handle: RePEc:spr:reaccs:v:15:y:2010:i:2:d:10.1007_s11142-010-9119-2
    DOI: 10.1007/s11142-010-9119-2
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    Keywords

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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting

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