Innovations, real options, risk and return: Evidence from the pharmaceutical and biotechnology industries

Based on recently developed real options models, such as in Berk, Green and Naik (1999, 2004), I develop and test hypotheses about the impact of growth options embedded in innovative investment on the risk and the expected return of a firm's equity. I test my hypotheses using a hand-collected dataset on the major innovation activities undertaken by pharmaceutical and biotech firms over the period 1985-2004. The dataset contains detailed information on 112 innovation-targeted acquisitions, 273 highly-innovative drug introductions and 211 key patent grants underlying these drugs.; I find significantly positive abnormal stock returns around the announcements of patent and new drug applications and approvals, and negative abnormal stock returns around acquisition announcements. These results suggest that innovative events provide value-relevant information to the stock market. To examine whether changes in firm value around the events are in part due to predicted revisions in expected return on equity, or cost of equity capital, I study medium-term post-announcement returns. The results are mixed. I find that patent-related events are followed by positive abnormal returns, which is consistent with the prediction that investors require higher return following the discovery of a relatively risky growth option. However, I find that new drug applications are also followed by positive abnormal returns, which contradicts the prediction that expected returns decline following the conversion of a growth option into relatively safe assets in place.; I then examine the central prediction of the real options models that the new information about growth options affects expected returns by changing a firm's equity risk. I do not find that the events significantly affect the systematic risk of innovating firms. Furthermore, changes in the systematic risk do not explain abnormal returns around the event announcements. Taken together, these results do not support the main prediction of real options theory that the systematic risk and hence the expected return of individual firms change in a predictable manner in response to information about growth options embedded in innovative investment.