Continuation Options and Returns-Earnings Convexity

Abstract

We hypothesize and provide evidence that convexity in the returns-earnings relation results in significant part from firms' real continuation options, i.e., their discretionary ability to continue operations, to make new investments, and to raise capital when financing deficits arise. We estimate convexity using spline regressions for sequential partitions of the sample based on proxies for general optionality, liquidation likelihood, and continuation optionality. We develop four measures of convexity that capture the positive implications of earnings uncertainty from the perspective of equityholders. We predict and find that all four measures are significantly positively (negatively) associated with firms' future equity (debt) financings. These results suggest that our convexity measures have general usefulness for research in accounting and finance, which typically focuses on the negative implications of earnings uncertainty.