Working Paper: NBER ID: w18836
Authors: Holger Kraft; Eduardo S. Schwartz; Farina Weiss
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.
Keywords: firm value; growth options; Tobin's Q; idiosyncratic volatility; R&D expenses
JEL Codes: G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| R&D firms (O32) | stronger effect of volatility on Tobin's Q (C58) |
| firm-level volatility (D25) | Tobin's Q (G19) |
| idiosyncratic volatility (G19) | Tobin's Q (G19) |
| idiosyncratic volatility (G19) | firm valuations (G32) |
| unsystematic volatility (C58) | Tobin's Q (G19) |
| stock returns (G12) | contemporaneous idiosyncratic volatility (non-R&D portfolios) (G19) |
| idiosyncratic volatility (G19) | positive alphas (R&D portfolios) (O32) |