Examining the Price-Earnings Relation in a Real Options Framework with Investor Learning

Abstract

This study examines how the price-earnings relation varies with the uncertainty about and the quality of a firm's investments. We use a real options valuation framework to capture optimal investment and abandonment options in the biotechnology industry. Based on a simulation analysis, we predict that the price-earnings relation is V-shaped, and changes over the life cycle of a firm. Also, as investors learn about the quality of the firm over time, they will value accounting losses and profits more in higher quality firms. Our empirical findings are based on a sample of 333 biotechnology firms with an IPO between 1980 and 2000, and are generally consistent with our predictions. We contribute in several ways to the existing price-earnings literature. First, we provide a theoretical explanation for the significant negative price-earnings relation for loss firms. Second, we show how the price-earnings relation changes over time as investors learn about the quality of the firm. Third, we provide a real options valuation model that is better suited for valuing growth firms than the more traditional DCF based models (including the Ohlson model). We show how nonfinancial information affects the valuation of earnings.