Growth Options and Firm Valuation

Holger Kraft, Eduardo S. Schwartz, Farina Weiss

NBER Working Paper No. 18836
Issued in February 2013
NBER Program(s):   AP

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. 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. Single sorting on idiosyncratic volatility yields a significant negative relation between portfolio alphas and contemporaneous idiosyncratic volatility 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 control for several explanatory variables simultaneously, we also run panel regressions of firm-level alphas which confirm the relative importance of idiosyncratic volatility that is amplified by R&D expenses. Finally, we show that our results are robust to the definition of idiosyncratic volatility. We tease out the "true" idiosyncratic volatilities by performing a principal-component analysis on the residuals of Fama-French regressions and find that our main results still hold for this alternative definition of idiosyncratic volatility.

download in pdf format
   (404 K)

email paper

This paper was revised on April 19, 2017

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w18836

Users who downloaded this paper also downloaded* these:
Aghion, Akcigit, and Howitt w18824 What Do We Learn From Schumpeterian Growth Theory?
Albuquerque, Eichenbaum, and Rebelo w18617 Valuation Risk and Asset Pricing
Bloom w12841 Uncertainty and the Dynamics of R&D
Lettau, Maggiori, and Weber w18844 Conditional Risk Premia in Currency Markets and Other Asset Classes
Kogan and Papanikolaou w17975 A Theory of Firm Characteristics and Stock Returns: The Role of Investment-Specific Shocks
NBER Videos

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email:

Contact Us