Real Option Based Equity Valuation Models: An Empirical Analysis

This paper provides empirical evidence in support of real option based equity valuation models that relate share price to accounting earnings and book value. Our empirical results are generally consistent with the predictions of several models, all of which are based on real options theory. However, we find that the basic model, which includes components related to put and call options, fits the data more efficiently and parsimoniously than do models modified for the level of firm efficiency (i.e., accounting profitability measured as the return on common equity book value). We also find that the fit of the basic model and the derived coefficients vary with firm efficiency as measured by accounting profitability. We also test for the impact of capital structure on equity valuation and find some evidence for the relevance of debt for loss firms (i.e., low efficiency firms) and growth firms. We find anomalous results for loss firms, consistent with previous research, and provide an explanation for them. Our research contributes to the valuation literature by studying the empirical validity of a general real option based model and thus extends previous empirical studies that were based more or less on an options approach. Our contribution is significant in that there have been many theoretical papers on real options, but few empirical studies of the predictions of these models.