Joint Meeting of the Mid-Atlantic and Northeast Regions

Cross-Sectional Variations in the Valuation Role of Investment Growth

• In Event: Firm Valuation

Abstract

Real options models show a stepwise increase in the value-earnings association as accounting profitability increases and guides managerial investment decisions. However, we expect the role of investment growth in valuation to vary depending upon whether tangible or intangible investments support the investment growth. We find that value is less strongly associated with earnings when intangibles support investment growth. We attribute this finding to underinvestment in intangibles under the mandatory expensing accounting regime. We also find that the differential value-earnings association between tangible and intangible investments is higher in financially constrained firms. We attribute this finding to the fact that financial constraints curtail or delay investments with high payoff uncertainty such as intangibles. Lastly, we find that the differential value-earnings relation is limited to firms with low compensation convexity. We attribute this finding to the efficacy of managerial risk-taking incentives because option vega induces executives to take up risky intangible investments. We contribute to the literature by documenting cross-sectional variations in the valuation role of investment growth.

Authors

• Paul Irvine, TCU

• Shin Hyung Kwon, Hanyang University ERICA

• Steve C Lim, Texas Christian University