Earnings and Equity Valuation in the Biotech Industry: Theory and Evidence

Abstract

This study examines how the price-earnings relation varies with the uncertainty about and the quality of a firm's investments. We develop a real option valuation framework to capture optimal investment and abandonment options in a research-intensive emerging technology, the biotechnology industry. Both management and investors resolve uncertainty about the firm quality over the life cycle from observing past investment successes and failures. We predict that the price-earnings relation is V-shaped and changes over the firm life cycle. Also, as investors learn about the quality of the firm over time, they will value accounting losses and profits more in higher quality firms. Our empirical findings are based on a sample of 301 biotechnology firms with an IPO between 1980 and 2000, and are generally consistent with our predictions. We contribute in several ways to the existing price-earnings literature. First, we provide a theoretical framework for the significant negative price-earnings relation for loss firms. Second, we show how the price-earnings relation changes over time as investors learn about the quality of the firm. Third, we provide a real option valuation model that is better suited for valuing option-intensive firms than the more traditional DCF based models. In addition, we show how nonfinancial information affects the pricing of earnings.

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