We study whether investment options are fairly priced by market participants. For this purpose, we build and estimate a real options model of optimal investment in the presence of uncertainty. We then classify stocks into undervalued and overvalued based on the difference between model-implied and observed firm values. A long-short strategy that buys stocks classified as the most undervalued by the model and shorts the most overvalued stocks generates annualized alphas from major asset pricing models that range between 10\% and 17\% for value-weighted portfolios. This relation between estimated misvaluation and future returns is only present within subsamples of firms with relatively high fractions of investment options to existing assets. We interpret these findings as evidence of investors having difficulties in valuing investment options, which leads to mispricing in equity markets that is gradually corrected over time.
Authors:
Evgeny Lyandres (Boston University), Egor Matveyev (University of Alberta), Alexei Zhdanov (Pennsylvania State University)
Discussant:
Andrea Gamba (Warwick Business School)