The Impact of Reputation on Stock Market Value

Simon Cole - February 2013

1.   Introduction

Corporate reputations rank amongst the most familiar but least understood of a firm’s assets. No survey research based metrics offer any real insight into how valuable they actually are or indeed, what can be done to secure and build the value they represent. Black and Carnes (2000) argued that corporate reputations contribute to a firm’s value but they did not identify “a method for evaluating and measuring, in dollar terms, an individual firm’s reputation”. This paper addresses that shortcoming and offers a guide for investors and corporations.

The need to measure the impact of reputation on market value has become increasingly urgent. By the start of 2012 the tangible book or net asset value of companies in the S&P500 accounted for only around 49% of market capitalisation; 55% in the FTSE100. Earnings expectations and other financials helped account for some of the shortfall but the bulk is a function of intangibles, identifiable and unidentifiable. This creates a variety of problems. First, it reduces the veracity of investors’ valuation calculations. Second, it limits their ability to take a suitably measured account of reputation events – actions that may materially affect a company’s value. Third, it inhibits reputation owners (i.e. the companies themselves), from managing their reputation assets in a truly objective and ultimately strategic manner.

Valuation methods have advanced over the last two decades but they invariably fall short when assessing corporate brands i.e. those that relate to the business as an operating entity rather than its products or services. Brand valuation techniques based on consumer transactions assess ,for example, operating brands like Diageo’s Guinness, Johnny Walker, Captain Morgan, Jose Cuervo and so on. But because none of them are branded ‘Diageo’ the corporate brand does not have any material impact on customer choice. As a result no economic earnings can be attributed and its economic value is defaulted to zero.

Clearly, this is not the case. Diageo like a host corporate brands is a global blue chip listed on a number of stock markets around the world and there are widely used survey research studies that testify to the fact that it commands a suitably well rated corporate reputation. The issue is not that corporate brands do not have any value but that traditional techniques aren’t geared up to identify it.

 

2.   Calculating Company Reputation Value

Corporate brands influence a variety of different stakeholders to create value in a number of different ways. The most important group however is investors. Investors buy or hold a company’s stock on the basis of the economic returns they expect to generate from either capital growth or future dividends and will sell it if they believe they can achieve better returns elsewhere. New information, intelligence and insight is filtered through the stock of extant impressions that add up to the company’s reputation and any changes may add to or detract from it. As a result reputation informed investor confidence flows through the market to influence the stock price.

The emerging hypothesis i.e. that a company’s market capitalisation can be explained by a combination of financial and reputational variables, was tested in a four part process: investigation, data collection, modelling and measurement.

Investigation

First, eighteen qualitative interviews were conducted with a selected group of buy and sell side investment analysts working with major investment banks, fund managers and agency and client side investor relations professionals. This identified the ‘wide’ set of influential or potential ‘explanatory’ variables to be assessed in the main body of the analysis.

Data Collection

Second, data were collected from a variety of sources to represent each variable. Reputation data were derived from the ‘Most Admired Companies’ reports published by Management Today in the UK and Fortune in the US. These are based on survey research studies conducted (entirely separately) amongst samples of ‘professional’ observers i.e. people who have a view of the brand as a business overall not just its products or services. The sample included c-suite individuals (senior and board level executives including ‘chief executive officers’, ‘chief communications officers’, ‘chief financial officers’ etc’)  from many of the largest public companies in each market along with selected investment analysts and business journalists.[1]

The Most Admired studies report perceptions of a comprehensive set of factors judged to be among the principal components of corporate reputation. These constitute the basic make up of each company’s reputation and are presented in the form of quantitative measures of the ‘strength’ of perceptions of the following dimensions:

·         Quality of management

·         Innovation

·         Quality of goods/products and services

·         Community & environmental responsibility (UK) / Social responsibility (US)

·         Financial soundness

·         Long term investment value

·         Use of corporate assets

·         Ability to attract talent (UK)

·         People management (US)

·         Quality of marketing (UK)

·         Global competitiveness (US)

Measures of the overall ‘strength’ of a company’s reputation are derived from a simple average of the ratings of the individual dimensions. Prior to any statistical analysis the data was cleaned and consolidated into a basic data set of close to 180 companies in the UK and 320 in the US.

Financial data were sourced from Factset and Bloomberg. The data comprised reported and consensus forecasts from relevant industry analysts of a number of relevant variables such as income and balance sheet data, financial ratios, EBITDA, dividend yields, betas etc.

Modelling

Third, ‘general’ investor behaviour was modelled using econometric analysis to determine if reputation operates as a primary driver of market capitalisation and to quantify the extent of any influence. Reputation was introduced into the analysis as a singular ‘whole’ and at the level of its component parts. This helped determine which of the nine factors were most influential along with their relative impact.

This modelling took the analysis well beyond the empirical work described by Schwaiger (2004) that had explored the idea that the investment community does not see and value reputation in a one-dimensional temporal sense but rather, a two-dimensional one in which reputation is divided into affective (sympathy) and cognitive (competence) components. Extending this work into nine dimensions s allowed for richer models that demonstrate the possible negative trade-offs that exist between measures aimed at enhancing a firm’s reputation in terms of corporate responsibility at the expense of short-term performance.

Initial modelling was carried out using UK company data relating to the end of 2007. Once completed the process was repeated annually until the most recent iteration relating to the end of 2012. The analysis was also repeated for US listed companies on the assumption that the underlying hypothesis was not country specific and therefore should hold in any developed equity market given that equity investors behave in a broadly similar fashion. The analysis was completed for five separate years using US listed companies and reputation data from Fortune’s ‘World’s Most Admired Companies’. The results regarding the model form were entirely consistent, thereby providing further evidence as to its general veracity.

Measurement

The fourth and final stage of the analysis involved using the model to calculate a combination of reputation metrics for each of the companies in the data base. Predicted values of the market capitalizations of each company were calculated and from that a series of leading indicator outputs were produced. They included:

·   Reputation Contribution – the proportion of a company’s market value attributable to its reputation. The primary measure of reputation value.

·         Reputation Leverage – the extent of the return that can be expected from a specific increase in overall reputation strength (expressed in terms of increased market value).

·         Reputation Risk Profile – On the basis that extant reputation value is by definition value at risk – it can disappear without appropriate support – the Reputation Risk Profile spells out how it is distributed between its individual components. In short, it details the scale of reputation value resident in each individual component of the company’s reputation.

 

 

 

3.   Conclusions

Corporate reputation is a powerful driver of shareholder return

The implications of the analysis are clear. Company reputations are real, present and often very substantial assets. Their economic impact is considerable in both the UK and the US where they rank amongst the most important repositories of value of listed companies in each jurisdiction. As of January 1^st 2012 they accounted for close to 26% of the total market capitalization of the S&P500, or US$3,190bn of shareholder value.  At the same time they were delivering US$770bn of value across the FTSE100 and US$67bn across the FTSE250.

Reputation returns vary from company to company

The value of individual corporate reputations varies considerably. There are winners and there are losers. Across the 410 leading US and UK companies tracked at the start of 2012 they ranged from a height of close to 58% (Apple) to a low of -39% (Sears Holdings). In most cases, 91% of companies, reputation is a force for good and is creating shareholder value. However, in the remaining 9% it is negative and destroying value. The top 25 leaders and bottom 25 losers aggregated across both markets with the impact of reputation (positive or negative) valued in US$ as at January 2 2012 are shown in Tables 1 and 2.

As a group, the 25 companies with the highest Reputation Contributions across both countries at the start of 2012 had aggregate benefits valued at US$1,707bn.

Conversely, shareholders of the 25 companies with the lowest Reputation Contributions were losing US$16bn as a result of those companies’ reputation weaknesses.

 

 

Reputation Value is driven by much more than strength alone

The potency and thus contribution of a reputation is dependent on much more than just strength. This is clear when the two are compared directly as in Chart 1 below where each point represents a different company.

Companies with a reputation strength of, for example, 6.5 (measured on a scale of 0 to 10) are showing corresponding Reputation Contributions ranging from around 20% to 43%, a spread of 23 % points. Similarly, companies with a Reputation Contribution of around 45% have reputation strengths ranging from around 6.67 (out of 10) to over 8.

 

Equally, Reputation Contributions have changed over time without any significant movement in the strength of the underlying reputations. While the average Reputation Contribution in the FTSE100 doubled in the four years to 2011 and increased by half in the S&P500, the average strength of the underlying reputations was only marginally changed. Reputations have become more valuable but more because of what they ‘provided’ investors with than simply how well they stood out.

Reputation strength has a part to play but there are other factors at work. These relate to the make-up of individual corporate reputations. Clearly, it’s not just how well a company is known, it’s what it’s known for that counts and investors need to look beyond the simple measures of strength if they want to understand the impact of corporate reputation properly.

Reputation management is a means to grow shareholder returns

Reputation is not just a repository of shareholder value, it is also a means to grow it. This analysis suggests that a notional 5% improvement of the strength of an extant reputation would yield a market capitalization growth of 2.5% for the average S&P500 company and 2.2% in the FTSE100. While there are differences from index to index this equates to a return on investment of around US$600m for an average sized S&P500 (market cap cUS$24bn) and US$500m for a correspondingly average sized FTSE100.

Incremental value growth depends on the individual reputation that’s being built up. Reputations of different companies are structured in different ways and they offer different potential for ‘leverage’ – the increase in market capitalization that can be expected for any improvement in general reputation strength. As a rule, less valuable reputations will provide less opportunity for value growth however, there is substantial variation and thus room for individual reputation managers to manoeuvre within that.

Reputation management depends on individual reputations

Reputation growth is determined by changes in the individual reputation components. Companies will achieve disproportionately greater returns on their reputation management investment by ensuring that their communications activity is aligned to promote the messages that matter most to investors at the time. While the general requirements of corporate messaging may, in the broadest sense, remain consistent, it’s clear that the ‘needs’ of the investment community are a movable feast.

This study uncovered important evidence of changes in the priorities allocated to different components of reputation. The data revealed that in 2012 the investment community had started to look beyond companies focussed on the more defensive characteristics of ‘quality of leadership’ and ‘quality of products/services’ and is responding more favourably to those companies it sees as ‘innovating’, ‘attracting talent’ and ‘investing in marketing’. They were increasingly eschewing shorter term defensive qualities and rewarding companies they perceive to be geared up to capitalise on the changing economic cycle and preparing for the upturn.

Reputation value analytics represents an important step forward in the strategic management of corporate reputation. Moreover, it has important implications for both the owners and managers of corporate brands and for the investors who target them. First and foremost because it reveals the scale and location of shareholder value residing in a company’s reputation and second because it provides an objective basis for securing and growing value further.

This analysis presents reputation owners with an objective basis to organise communications and broader based operational or strategic activities to manipulate and ultimately optimise the reputation component of a firm’s market value. It answers important questions: where the messaging opportunities are?; can the company sustain a stronger reputation i.e. is it being unfairly under-rated in any way?; and, is the return on the investment required reasonable? Answers to all of these questions can have a critical impact on investors’ decisions as to whether or not to support any individual company.

The work of Reputation Dividend is not a panacea for a company’s reputational shortcomings, but it can reveal the most pressing value generating or destroying components. Moreover, by disentangling the individual drivers of reputation value it can shed light on whether issues are truly messaging problems, operational problems, strategic problems or some combination of the three. Finally, in providing hard numbers that reflect the magnitude of the reputation drivers in a language that is simple and relevant to corporate leaders it will command a high degree of credibility and utility for publicly owned companies and their investors.

References

Black, E.L. and Carnes T.A, (2000) The Market Value of Corporate Reputation, Corporate Reputation Review, Vol. 3, No. 1, 31-42

Schwaiger, M, (2004), Components and Parameters of Corporate Reputation – An Empirical Study, Schmalenbach Business Review, Vol. 56, January, 46-71