Growth Options and Firm Valuation

Abstract

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.

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