Valuing Loss Firms

Baruch for helpful comments on earlier drafts. A previous version of this paper was titled " Loss reversals and earnings-based valuation. " All errors are our own. Abstract We hypothesize that when confronted with a loss, investors price earnings conditional on the likelihood of the firm's return to profitability. We argue such pricing is consistent with the abandonment option hypothesis as described by Hayn (1995) and show both the pricing of losses and their characteristics vary as a function of their expected reversal. We document a more pronounced stock price response to transitory losses (i.e., losses likely to reverse), consistent with investors assessing the likelihood of exercising the abandonment option to be smaller. However, we also find evidence consistent with investors pricing persistent losses (i.e., losses not likely to reverse) negatively, a result inconsistent with the abandonment option hypothesis. Further analysis shows investors price the components of losses differently depending on the likelihood of reversal. Aggregate accruals explain the pricing of persistent losses while aggregate cash flows explain the pricing of transitory losses. The result for persistent losses relates to the presence of an increasingly larger R&D component: investors reward firms that make larger R&D outlays with larger returns. One consequence of the growing R&D component in persistent losses is that they have become a weaker indicator of the likelihood of exercising the abandonment option. Data Availability: Data are available from sources identified in the text.