Return predictability and the real option value of segments

Pingui Rao (), Heng Yue () and Xin Zhou ()
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Pingui Rao: Jinan University
Xin Zhou: XY Investments

Review of Accounting Studies, 2018, vol. 23, issue 1, No 5, 167-199

Abstract: Abstract Theory suggests that firm value should include the value of real options; that is, firms have the option to expand more profitable businesses and liquidate less profitable businesses. In a diversified firm, each segment has its own real options. Applying real options theory to a diversified firm at the firm level neglects the value of segment-level options. If investors overlook segment-level options, mispricing will occur. Using data from 1981 to 2013, we find that a hedge portfolio buying diversified firms in the highest decile of the estimated real option value of segments (RVS) and selling those in the lowest RVS decile earns a significant 0.79% size-adjusted monthly return. The hedge returns are more significant for firms whose growth opportunities mainly lie in the more profitable segments. We also find that the predictive power of RVS is stronger for firms with high growth, lower analyst coverage, and stronger corporate governance. Further investigation links improved operating performance to the exercise of segment-level real options.

Keywords: Real option value; Return predictability; Abnormal returns; Segment (search for similar items in EconPapers)
JEL-codes: G12 M41 (search for similar items in EconPapers)
Date: 2018
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Citations: View citations in EconPapers (2)

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DOI: 10.1007/s11142-017-9421-3

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