Does the Market Correctly Value Investment Options?
Evgeny Lyandres, Egor Matveyev, Alexei Zhdanov
Review of Finance, Volume 24, Issue 6, November 2020, Pages 1159–1201, https://doi.org/10.1093/rof/rfaa002
Investment options are one of the most important components of firm value. At the same time, they are notoriously difficult to value. Not only is it difficult to forecast future cash flows of a growth firm, but its business risk also changes when investment options are exercised. Common valuation tools used in practice, such as discounted cash flow (DCF) method, do not take into account the optionality embedded in investment decisions and usually use constant discount rates. As a result, investment options may get mispriced.
The goal of this paper is to understand whether the market systematically misprices investment options. We build a real options model of optimal investment under uncertainty that mitigates challenges of the DCF approach. We estimate our model on a broad cross-section of publicly traded U.S. firms. Our implementation approach allows us to estimate theoretical firm value each month for each firm, and to decompose it into the value of assets in place and the value of growth options.
The major result of the paper is that investment options are indeed often mispriced. This mispricing persists for up-to 12 months and is not explained by common risk factors. We show that firms take advantage of such mispricing. In particular, undervalued firms are more likely to buy back their shares and overvalued firms are more likely to issue new equity. Corporate insiders of overvalued firms sell more shares compared to insiders of undervalued firms. Undervalued growth firms are more than twice as likely to be acquired as overvalued growth firms.
An important feature of the mispricing pattern that we uncover is that it is largely symmetric. Firms with valuable investment options are as likely to be undervalued as they are to be overvalued. This result makes an important contribution to the current debate on the stock market myopia. A common argument in this debate is that investors’ inability to fully appreciate the value of growth options puts pressure on firms to deliver short-term results, leading to distortions in corporate investment, which, in turn, compromises future growth.
Our finding that investment options may be both undervalued or overvalued challenges the notion that public equity markets systematically underprice growth firms. This result can be interpreted as evidence against short-termism of the stock market.