Cross-sectional variations in the valuation role of investment growth

Abstract

Real options models show a stepwise increase in the value-earnings association as accounting profitability increases and guides managerial investment decisions. However, we expect the role of investment growth in valuation to vary depending upon whether tangible or intangible investments support the investment growth. We find that value is less strongly associated with earnings when intangibles support investment growth. We attribute the differential value-earnings association across tangibles- vs. intangibles-supported investment growth to underinvestment in intangibles under the mandatory expensing accounting regime. We also find that the differential value-earnings association is increasing in financial constraints. We attribute this finding to the fact that financial constraints exacerbate the underinvestment problem by curtailing or delaying risky intangible investments. Lastly, we find that the differential value-earnings relation is limited to firms with low compensation convexity. We attribute this finding to the efficacy of managerial risk-taking incentives of compensation convexity because option vega helps mitigate the underinvestment problem by inducing executives to take up risky intangible investments. We contribute to the literature by documenting cross-sectional variations in the feedback role of accounting profitability.