Firm Valuation Over Lifecycle: A Perspective on Growth Option

• Author: Qiang Li,Yong Zeng,Hao Liu
• DOI: http://doi.org/10.1111/ajfs.12236
• Date: 01 October 2018
• Published date: 01 October 2018

Firm Valuation Over Lifecycle: A Perspective

on Growth Option*

Hao Liu

School of Management and Economics, University of Electronic Science and Technology, China

Qiang Li**

School of Management and Economics, University of Electronic Science and Technology, China

Yong Zeng

School of Management and Economics, University of Electronic Science and Technology, China

Received 4 April 2018; Accepted 9 June 2018

Abstract

This paper investigates the roles of the dynamic of growth options in determining possible

change trends of firm valuation over a firm’s lifecycle. The theoretical results show that the

gradual exercising of endowed growth options will cause a downward trend of firm valuation

over lifecycle, while the creating of new growth options can mitigate the downward trend. In

particular, there may be an upward trend of firm valuation for firms able to continually cre-

ate growth options over time. The evidence on 2354 Chinese listed firms during the period

of 1998–2015 supports theoretical predictions well.

Keywords Capital investment; Firm lifecycle; Firm valuation; Growth option; R&D expendi-

ture

JEL Classification: G10, G30

1. Introduction

Generally speaking, a firm will gradually run out of its growth opportunities as it

becomes mature (Fama and French, 2001; DeAngelo et al., 2006). Meanwhile, a

*This paper benefited from the comments and suggestions provided by the editor and anony-

mous referees, as well as from seminar participants at the 10th, 12th, and 13th International

Symposium on Financial System Engineering and Risk Management and the 11th and 13th

Chinese Finance Annual Meeting. This work was supported by the National Natural Science

Foundation of China (Grant no. 71102054 and 71472025) and The Fund for Cultural Celeb-

rity and Talents (Grant no. 2015/49). All errors are those of the authors.

**Corresponding author: School of Management and Economics, University of Electronic

Science and Technology of China. Tel: +86-139-0821-9395, Fax: +86-28-6183-0901, email:

liq@uestc.edu.cn.

Asia-Pacific Journal of Financial Studies (2018) 47, 720–743 doi:10.1111/ajfs.12236

720 ©2018 Korean Securities Association

firm can renew its growth opportunities as a result of technological innovation that

is an important determinant of a firm’s long-term core competitiveness (Dosi,

1988). R&D investment not only has the potential to improve firm valuation

(Szewczyk et al., 1996), but also enable firms to survive in the market in the longer

term (Garc

ıa-Quevedo et al., 2014).

The purpose of this paper is to explore how the dynamic of growth opportuni-

ties over a firm’s lifecycle determines the possible change trends of its market valua-

tion. In general, as a firm gradually exercises its limited growth opportunities, its

market valuation will present a downward trend. However, some firms do not just

passively conform to the reduction or even the disappearance of growth opportuni-

ties, they are able to actively create new growth opportunities by innovation activi-

ties to avoid being driven out of the market. As a result, the decrease of firm

valuation over the firm’s lifecycle will be slowed down and the market valuation of

firms continually engaging in R&D investment may exhibit an upward trend as

their lifecycle proceeds.

Existing empirical evidence suggests that firm valuation will decline over

time, and there are five possible reasons for this phenomenon. The first explana-

tion is related to uncertainty about profitability and investors’ learning. Where

the market-to-book ratio (MB ratio) tends to decrease with a firm’s listing age,

Pastor and Veronesi (2003) demonstrate that a firm’s MB ratio is positively

related to uncertainty about average profitability, and argue that the uncertainty

as well as the MB ratio will decline over time for the reason that rational inves-

tors will gradually update their beliefs relating to uncertainty about profitability

over time.

The second explanation is related to initial public offering (IPO) timing.

1

Chay

et al. (2015) find that MB ratio will decrease with firm age after IPO on the Korean

stock market. Because private firms can choose an optimal time to go public when

their expected future profitability is sufficiently high, it is the decrease of post-IPO

profitability that results in a decline of firm valuation after IPO.

The third explanation that is most relevant to our paper is the argument based

on the relation between organizational inflexibility and the creation of growth

opportunities over firm lifecycle. Loderer et al. (2016) argue that firms are inclined

to be optimally more rigid over time in order to focus on managing assets-in-place

efficiently rather than on finding new growth opportunities, and hence a fall of

Tobin’s Qis exactly the result of the inability of managers to renew growth oppor-

tunities over time.

The last two explanations are consistent with the financial constraint hypothesis

and agency problem hypothesis, respectively. Cooley and Quadrini (2001) point out

that firms with financial constraint prefer to undertake the most valuable projects

first and then the less valuable projects are undertaken as financial constraint is

1

See literatures such as Jain and Kini (1994), Pastor et al. (2009) and Chemmanur et al.

(2010).

Firm Valuation Over Lifecycle

©2018 Korean Securities Association 721