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Growth options and firm valuation

  • Kraft, Holger
  • Schwartz, Eduardo
  • Weiss, Farina
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    This paper studies the relation between firm value and a firm's growth options. We find strong empirical evidence that (average) Tobin's Q increases with firm-level volatility. However, 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 also document that only idiosyncratic volatility (ivol) has a significant effect on valuation. Second, we analyze the relation of stock returns to realized contemporaneous idiosyncratic volatility and R&D expenses. Single sorting according to the size of idiosyncratic volatility, we only find a significant ivol anomaly for non-R&D portfolios, whereas in a four-factor model the portfolio alphas of R&D portfolios are all positive. Double sorting on idiosyncratic volatility and R&D expenses also reveals these differences between R&D and non-R&D firms. To simultane-ously control for several explanatory variables, we also run panel regressions of portfolio alphas which confirm the relative importance of idiosyncratic volatility that is amplified by R&D expenses.

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    File URL: http://econstor.eu/bitstream/10419/88712/1/775663506.pdf
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    Paper provided by Research Center SAFE - Sustainable Architecture for Finance in Europe, Goethe University Frankfurt in its series SAFE Working Paper Series with number 6.

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    Date of creation: 2013
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    Handle: RePEc:zbw:safewp:6
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    1. Fu, Fangjian, 2009. "Idiosyncratic risk and the cross-section of expected stock returns," Journal of Financial Economics, Elsevier, vol. 91(1), pages 24-37, January.
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    17. Charles Cao & Timothy Simin & Jing Zhao, 2008. "Can Growth Options Explain the Trend in Idiosyncratic Risk?," Review of Financial Studies, Society for Financial Studies, vol. 21(6), pages 2599-2633, November.
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