Equity Misvaluation and Default Options

We study whether default options are mispriced in equity prices by employing a structural equity valuation model that explicitly takes into account the value of the option to default (or abandon the firm) and uses firm-specific accounting inputs. We implement our model on the entire cross-section of stocks and identify both over- and underpriced equity. An investment strategy that buys stocks that are classified as undervalued by our model and shorts overvalued stocks generates an annual 4-factor alpha of about 11% for U.S. stocks. The model’s performance is stronger for stocks with higher value of default option, such as distressed or highly volatile stocks. We find similar results in a sample of nine most highly capitalized developed markets.