Return predictability and shareholders’ real options

Lee-Seok Hwang and Byungcherl Charlie Sohn ()
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Lee-Seok Hwang: Seoul National University
Byungcherl Charlie Sohn: City University of Hong Kong (CityUHK)

Review of Accounting Studies, 2010, vol. 15, issue 2, No 6, 367-402

Abstract: 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.

Keywords: Abandonment (liquidation or adaptation) option; Residual income model; Abnormal earnings; Real options model; Return predictability (search for similar items in EconPapers)
JEL-codes: G12 M41 (search for similar items in EconPapers)
Date: 2010
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DOI: 10.1007/s11142-010-9119-2

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