Date Added: Aug 2010
The idea that uncertainty about a firm's long-run profitability could increase its stock valuation has been proposed by Pastor and Veronesi (2003) to explain a number of phenomena in financial markets. The authors further examine this idea by analyzing a simple valuation model for both stocks and bonds, in contrast to the existing studies focusing on stocks only. Unless a firm is deeply in debt, their model implies that uncertainty about a firm's profitability increases its stock valuation and decreases its bond valuation, where uncertainty's impact is stronger if the firm's leverage is higher. Using a number of existing uncertainty proxies in the literature and controlling for volatility, they empirically test these predictions.