Valuing loss firms

We investigate whether investors price losses conditional on the likelihood of the firm's return to profitability, consistent with the abandonment option hypothesis (Hayn 1995). We first develop a loss-reversal model to define subsamples of persistent and transitory losses. We find that on average investors price transitory losses positively over the sample period, as if a transitory loss indicates a low likelihood of exercising the abandonment option. We also observe that early in the sample period investors do not price persistent losses, as predicted by the abandonment option hypothesis. By contrast, later in the sample period, larger persistent losses correspond to higher returns, inconsistent with the prediction of the abandonment option hypothesis. To understand why we observe a change in the valuation of persistent losses over the sample period, we study their components and establish the key role of R&D for their valuation. We find that investors do not price persistent losses without an R&D component, consistent with these losses indicating financial distress and a higher likelihood of exercising the abandonment option. However, when persistent losses contain R&D, investors separately value the R&D component as an asset and the non-R&D component as if it is a transitory loss. Thus, investors do not consider losses to be homogeneous, but consider the causes and nature of the loss to assess its long-term implications for firm value.