Return Predictability and the Real Options Value of Segments

The real options theory suggests that firm value should include the value of real options, i.e., a firm has the option to expand a more profitable business and the option to liquidate assets of a less profitable business. For a diversified firm, each segment has similar options. Applying the option-based valuation to a diversified firm only at the firm level neglects the real options value of its segments and leads to mispricing and subsequent abnormal returns. Using data from 1981 to 2013, we find that a hedge portfolio buying diversified firms with the highest decile of real options value of segments (RVS) and selling those with the lowest decile of RVS earns a significant 0.79% size-adjusted monthly returns. We also find that the hedge returns are more significant for firms with high growth, with good corporate governance, or with a lower level of analyst following. Further investigations indicate that firms improve operating performance by exercising their segment-level real options. Finally, we provide an alternative explanation for the well-documented diversification discount