What is the Value of an Innovation? Theory and Evidence on the Stock Market’s Reaction to Innovation Announcements

Courtesy of Thomas Chemmanur, Dongmei Li, Kevin Tseng, and Yu Wang

Recently, there has been considerable interest among economists in stock market-based measures of the value of corporate innovations. For example, in a recent paper, Kogan, Papanikolaou, Seru, and Stoffman (2017) develop a new measure of the economic value of a corporate innovation by making use of the stock market response to announcements of patent approvals. They show that their patent-level estimates of the economic value of patents are positively related to the scientific value of these patents (as measured by their numbers of citations) and to the subsequent growth rate of the firms holding these patents. However, one important factor that affects the stock market response to patent grant announcements is the level of attention paid by investors to such announcements. In particular, it is easy to imagine that a significant fraction of stock market investors do not pay much attention to news about patents whose future economic value is hard for anyone but a select few experts to evaluate. The objective of our paper, available here, is to analyze, theoretically and empirically, the effect of investor attention on the stock market response to innovation announcements and to incorporate the effects of the level of investor attention paid to an innovation announcement (such as a patent grant announcement) into a stock market-based measure of the economic value of a corporate innovation. To the best of our knowledge, this is the first paper in the literature to conduct such an analysis, either theoretically or empirically.

We first develop a theoretical model to analyze how differences in investor attention across different types of innovation announcements (e.g., a patent grant announcement versus an FDA drug approval announcement) affect the stock market response to these announcements, and to develop testable hypotheses. We then test these hypotheses using two different datasets: first, a matched sample of patent grants and subsequent FDA drug approvals from the biopharmaceutical industry; and second, a dataset on the universe of patent grants from the USPTO during 2000-2014, using media coverage as the proxy for the investor attention paid to various innovation announcements. We also document, for the first time in the literature, the presence of a positive stock return drift (on average) following patent grant announcements and show that this stock return drift following a patent grant announcement captures the economic value of the patent to some extent (over and above that captured by the announcement effect of the patent grant news).

Our Model

The stock market in our model consists of two kinds of risk-averse investors who allocate their wealth between a risk-free asset and the stock of the innovating firm: those who are fully (and immediately) attentive to innovation announcements (“attentive investors”) and those who temporarily neglect such announcements (but pay attention to these innovation announcements after some delay), since they are unable to immediately understand and interpret the cash flow implications of these announcements (“inattentive investors”).Our assumption here is that, while inattentive investors do not immediately incorporate the innovation announcement into their demands for the firm’s equity, they correct this lack of attention over the subsequent period. Further, we assume that the fraction of attentive investors in the equity market depends on the nature of the innovation announcement: the closer an innovation is to being monetized, the larger the fraction of investors in the stock market who are able to understand and interpret its cash flow implications immediately (attentive investors). To give an example, in the case of the biopharmaceutical industry, the fraction of investors who pay attention to the initial patent grant of a drug-related molecule may be much smaller than the fraction who pay attention to an announcement that the same molecule has undergone successful clinical trials and has been approved by the FDA.

In the above setting, we show that the equilibrium stock price after an innovation announcement (patent grant or FDA approval) will reflect the weighted average of the beliefs of attentive and inattentive investors, with weights depending on the fraction of each type of investor in the equity market. We further show that, immediately after an innovation announcement, the stock of the innovating firm may be undervalued or overvalued (depending upon whether the innovation announcement reflects positive or negative news). Such under-or overvaluation will not be immediately arbitraged away, since investors who are fully attentive to the innovation announcement are risk-averse and therefore willing to bear only a limited amount of risk in order to exploit the above mispricing. The above mispricing will therefore be corrected only in the subsequent period as a result of inattentive investors revising their beliefs as they better understand and interpret the cash flow consequences of the previous innovation announcement. This, in turn, implies that there will be a stock return drift subsequent to innovation announcements, the magnitude of which will depend upon the fractions of attentive and inattentive investors in the equity market (with respect to that announcement), and whose direction (positive or negative) will depend upon whether the innovation announcement carries positive or negative news.

Predictions and Results

The above model generates several testable predictions which we test in our empirical analysis. First, in a patent-drug matched sample, the abnormal stock returns upon patent grant announcements will be smaller than that upon FDA drug approval announcements (of the same molecule). Further, the stock return drift subsequent to the patent grant announcement of a given molecule will be greater than that subsequent to the FDA drug approval announcements for the same molecule. Second, our model predicts a positive relation between the extent of investor attention paid to a given patent grant announcement and the abnormal stock returns upon this announcement. Third, our model predicts a negative relation between the extent of investor attention paid to a given patent grant announcement and the post-announcement stock return drift following that announcement.

Our results support the implications of our model. First, in the biopharmaceutical sample, drug approval news is more salient and receives more investor attention than patent grant announcements; the announcement effect is higher, while the subsequent stock return drift is lower for drug approval announcements than for patent grant announcements. Second, in both the biopharmaceutical sample and the general USPTO sample, the announcement effect (on patent grants and/or drug approvals) increases with investor attention and the subsequent stock return drift decreases with investor attention. Third, among the six different technology categories: Chemicals (excluding Drugs); Computers and Communications (C&C); Drugs and Medical (D&M); Electrical and Electronics (E&E); Mechanical; and Others, our empirical results suggest that, while attention is an important determinant of the stock market reaction across all six technology categories, it is particularly important in two categories: Computers and Electronics. Fourth, we show that both the announcement effect and the stock return drift following patent grant announcements are statistically and economically significant, and they have predictive power for the future profitability, productivity, and growth generated by these patents for the firm developing them.

Finally, we analyze whether it is possible to trade profitably using the results of our empirical analysis on the relation between the stock market reaction to patent grant announcements and investor attention. To conduct this analysis, we construct a low-minus-high portfolio by holding a long (short) position in a portfolio with low (high) attention paid, on average, to the patents received by a firm (this measure, which we refer to as ATTP, is constructed at the firm-month level by averaging the attention paid to the patents granted to a firm in a given month). We show that such a portfolio is profitable on average, over the month immediately after patent grant announcements in our general USPTO sample.

Conclusion

Overall, we show, theoretically and empirically, that incorporating the effects of investor attention to patent grant announcements into a stock market-based measure of the economic value of patents granted to firms would considerably enhance the predictive power of such a measure for the future performance of the firms to which these patents are granted.

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