A New Value-to-Price Anomaly and the Idiosyncratic Risk

This study documents the prominent role of idiosyncratic risk in impeding arbitrage activities with regard to a new value-to-price anomaly. Using the real-option-based valuation model, we measure the intrinsic value of a firm’s equity (Vo) by explicitly incorporating the shareholders’ abandonment option into the residual-income-based value estimate. This new value-to-price (Vo/P) ratio has a unique return predictability after controlling for previously known risk factors. We find that this “Vo/P anomaly” is exacerbated by the idiosyncratic risk to a greater extent than by any other arbitrage risk factor, especially when the probability of exercising the shareholders’ abandonment option is high.