Disclosure, Uncertainty, and the Option Value of Equity

This study examines the link between disclosure, cash flow uncertainty, and the option value of equity. Building upon Merton (1974), I model the equity of a levered firm as a call option whose equilibrium value is increasing in the variance of future cash flows. Modeling levered equity as an option allows for calculation of the firm’s vega, where vega measures the sensitivity of equity value to increases in expected cash flow variance. Using multiple measures of disclosure, I find that higher vega firms are more likely to issue disclosures that increase or sustain expected cash flow variance, consistent with firms promoting uncertainty when the marginal benefit is high. Specifically, I find that higher vega firms are associated with increases in option-implied volatilities in short-windows surrounding managerial guidance. Higher vega firms are also less likely to issue guidance but, when doing so, their earnings guidance is less specific and followed by increases in analyst forecast dispersion. Similarly, I find a negative relation between vega and a hand-collected index of voluntary disclosures. Finally, I demonstrate a positive relation between vega and absolute earnings surprises suggesting that higher vega firms are less likely to pre-empt earnings news. Taken together, the results are consistent with the option value of equity creating incentives for firms to raise uncertainty through disclosures. ∗Contact e-mail: [email protected]. I would like to thank Mary Barth, Anne Beyer, Ilan Guttman, Travis Johnson, Dave Larcker, Charles Lee, Sebastian Infante, Andy Van Buskirk, Charles Wang, and Sean Wang for their helpful comments and suggestions. I am also grateful to Jennifer Francis, Dhananjay Nanda, and Per Olsson for providing me with data on voluntary disclosure scores. All remaining errors are my own. Financial support was provided by Stanford University’s Graduate School of Business and the Deloitte Foundation. E.So Disclosure, Uncertainty, and The Option Value of Equity 1