A value premium without operating leverage

The existing real options literature explains the value premium as a consequence of either operating leverage raising risk in low-demand states or industry-wide investment lowering risk in high-demand states. This paper presents a simple model in which a value premium arises solely from capacity constraints. Profit is more sensitive to demand shocks when there is excess capacity, and the book-to-market ratio is high, than when capacity constraints bind, and the book-to-market ratio is low. The option to adjust capacity weakens the value premium arising from assets in place, but does not eliminate it for a wide range of parameters.

► This paper explains the value premium in average stock returns in terms of constraints on production capacity. ► Operating cash flow is least sensitive to demand when capacity constraints bind and the book-to-market ratio is low. ► Operating cash flow is most sensitive to demand when there is excess capacity and the book-to-market ratio is high. ► Capacity-adjustment options weaken, but do not eliminate, the value premium.