Earnings momentum, adaptation value, and nonlinearities in the valuation of Chinese equity stocks

We demonstrate that when the variables comprising a firm’s investment opportunity set evolve in terms of the second derivatives of its abnormal earnings and information variables then the present value of the cash flows the firm expects to earn will be stated in terms of the levels and the momentum of the affected variables. It is also shown that the market value of a firm’s equity is comprised of the present value of the cash flows it expects to earn from operating under its existing investment opportunity set plus the value of the real options the firm possesses to modify or even completely change its existing investment opportunity set. Our empirical analysis, based on both Chinese and U.S. data, shows that earnings momentum and the adaptation and growth options which are typically available to firms all appear to have a significant impact on equity prices.