Financial Statement Information and Equity Value: The Role of Real Options Characteristics

This paper examines whether firm-specific real options characteristics are equity value-relevant beyond valuation estimates anchored in financial statements. Using extensive historical data for the United Kingdom, we assess and compare the forecast accuracy and explanatory power for stock prices of equity valuation models based on residual income and capitalized earnings against counterparts with add-on real options characteristics. Empirical results show that real options-augmented models enhance forecast accuracy and explanatory power, providing supportive evidence for the value of flexibility from managerial ability to expand, adapt, or abandon. Consistent with real options theory, further evidence shows that the incremental information content of firm-specific real options characteristics is more prominent in high business volatility firms, real options-intensive industries, firms with higher managerial decision-making discretion, and high growth potential firms. Our findings are robust to alternative measurement and sample specifications, accounting for analysts’ forecasts, and several other checks.