Return predictability and shareholders’ real options |
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Authors: | Lee-Seok Hwang Byungcherl Charlie Sohn |
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Institution: | (1) College of Business Administration, Seoul National University, 599 Gwanak-ro, Gwanak-gu, Seoul, 151-742, Republic of Korea;(2) Department of Accountancy, City University of Hong Kong (CityUHK), 83 Tat Chee Avenue, Kowloon Tong, Kowloon, Hong Kong, China;; |
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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. |
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