The impact of growth, volatility and competitive advantage on the value of equity investments and their embedded options

Hall, Jason. (2005). The impact of growth, volatility and competitive advantage on the value of equity investments and their embedded options PhD Thesis, School of Business, The University of Queensland.

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Author Hall, Jason.
Thesis Title The impact of growth, volatility and competitive advantage on the value of equity investments and their embedded options
School, Centre or Institute School of Business
Institution The University of Queensland
Publication date 2005-11-01
Thesis type PhD Thesis
Supervisor Prof Stephen Gray
Prof Terrance O'Keefe
Total pages 208
Collection year 2005
Language eng
Subjects 350301 Finance
710401 Finance and investment services
Formatted abstract This thesis examines the relationship between equity valuation and four value drivers - revenue growth, volatility, profit margin and competitive advantage. It is motivated by evidence that the predominant valuation techniques of equity analysts are not associated with improved portfolio performance. Prior research suggests that equity analysts devote considerable resources into forecasting near-term earnings, but derive target prices from those earnings in an almost arbitrary fashion. In contrast, the valuation techniques in the commercial world are increasing in sophistication. Around 30 percent of large corporations in the United States and Australia use real options analysis for project evaluation, according to recent surveys. Thus, the research question is whether sophisticated equity valuation, based on rigorous economic assumptions, is useful for investment decision-making.

Chapter 2 examines whether equity portfolios formed using Decision-tree or Discounted Cash Flow valuation models earn positive abnormal returns. These valuation models incorporate the assumption that abnormal returns on reinvested earnings are eroded over time. I form long-short portfolios on the basis of value relative to price at 30 April of each year from 1987-2004, by selecting stocks ranked in the top and bottom deciles, top and bottom quintiles and the top 30 percent versus the bottom 30 percent. I report annual excess returns of around 7 percent and a significant improvement in Sharpe ratios. Despite a strong relationship between value/price, size and market-to-book equity, this outperformance remains after controlling for these factors. Further, abnormal returns were most consistently earned by portfolios formed from a sub-sample of small growth stocks. The returns are consistent with the following explanation for the outperformance of value stocks - investors extrapolate past earnings and revenue growth for an unreasonably long competitive advantage period. The implication for portfolio managers is that there is merit to fundamental valuation techniques, provided they incorporate the assumption that firms' competitive advantage is unlikely to be sustained into perpetuity.

Chapter 3 measures the relationship between IPO underpricing and the proportion of equity value attributable to the firm's embedded options, referred to as Real option%. In estimating this proportion, I compute Discounted Cash Flow and Decision-tree valuations under the assumption that revenue growth, volatility of growth and profit margin revert to long-term sustainable levels over the firm's competitive advantage period. Consistent with information asymmetry theories of underpricing, there is a significantly positive association between initial returns and Real option%. The results are consistent with the value of embedded options being priced at a 10 percent discount to market value, in addition to any strategic underpricing. In contrast, the evidence suggests that information asymmetry does not prevent the Discounted Cash Flow component of equity value being fully incorporated into offer price.

Chapter 4 provides corroborating evidence that Real option% is a measure of the proportion of equity value comprised of embedded options. First, I show that Real option% is positively correlated with R&D-intensity and that around 30 percent of the variation in Real option% can be explained by R&D-intensity. Second, I show that Real option% and R&D-intensity have comparable association with the volatility of stock returns. Third, I estimate the market value of embedded options on a per share basis. When the market value of embedded options is estimated using capitalised R&D, the confidence interval around this value is comparable to that implied by Real option% under an assumed competitive advantage period of 20 or 30 years. When this confidence interval is estimated using R&D/Sales, it is comparable to that implied by Real option% under an assumed competitive advantage period of 10 years. Finally, I show that quintile portfolios formed on the basis of Real option% have comparable investment performance to those formed on the basis of R&D-intensity. Sharpe ratios for the top and bottom quintiles formed on Real option% were 0.40 and 0.41, respectively. Furthermore, Sharpe ratios of 0.34 and 0.38 were obtained for those same quintiles for portfolios formed on the basis of R&D/Sales. In sum, this analysis provides support for Real option% as a valid economic construct - the proportion of equity value comprised of embedded options.
Keyword Investment analysis
Corporations -- Valuation
Options (Finance)

Document type: Thesis
Collection: UQ Theses Collection (RHD) - Open Access
 
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Created: Tue, 09 May 2006, 10:00:00 EST by Jason Hall on behalf of Social Sciences and Humanities Library Service