Corporate Reputation Review

Volume 3 Number 1

The Market Valuation of Corporate Reputation

Ervin L. Black and Thomas A. Carnes University of Arkansas, Fayetteville Vernon J. Richardson University of Kansas, Lawrence

ABSTRACT We provide evidence that corporate reputation has value relevance, as measured by its ability to explain the rm's market value of equity at the end of the scal period. Corporate reputation is assessed using a summary measure from the Fortune survey of `America's most admired companies.' The Fortune measure serves as a proxy for intangible assets, such as internally generated goodwill, customer service, and intellectual capital. We demonstrate that this summary measure of non-nancial information adds to market value, even after controlling for the nancial performance `halo' eects on the Fortune ratings. INTRODUCTION Measurements of corporate reputation appear nowhere in the nancial statements, yet it is apparent to the most casual of observers that corporations expend vast amounts of time and money to burnish their reputations. Such expenditures, of course, are undertaken with the expectation of resultant benets to the corporation. The benets may not always be nancial in a direct sense (eg, corporate sponsorship of a community event may be a `good neighbor' gesture that does not translate into increased sales). But it has been shown that favorable reputations have rm-specic nancial benets to corporations by reducing the mobility of industry rivals (Caves and Porter, 1977; Wilson, 1985); by allowing rms to charge premium prices (Milgrom and Roberts, 1986); or by enhancing rm access to capital

markets (Beatty and Ritter, 1986). Firms appear to be `involved in a competitive market for reputational status in which, because of information asymmetries, rms signal their key characteristics to constituents' (Fombrun and Shanley, 1990). Corporate reputation therefore meets the customary accounting denition of an intangible asset, though it is not one that is specically identiable (in contrast to a patent or trademark). Instead, it is a qualitative asset, and the determination and timing of its future benets to the rm are extremely dicult to quantify, thereby posing serious valuation problems. Edvinsson and Malone (1997) refer to such assets as `invisible assets'. Despite the diculty in quantifying the worth of favorable corporate reputation, it should have value to the investor since it results in nancial benets to the corporation. As Edvinsson and Malone (1997) write, `Somehow, if only by hunches and intuitions, the market is putting a value on invisible assets. And some of these qualitative assets seem to hover in the ether almost indenitely, converting to line items on the balance sheet years after the market has accounted for them.' There is evidence regarding the value-relevance of corporate reputation: Fortune reports that a 1988 investment in its ten most admired companies would have grown to nearly three times as much by 1998 as would have a comparable investment in the Standard

Corporate Reputation Review, Vol. 3, No. 1, 2000, pp. 3142 # Henry Stewart Publications, 13633589

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The Market Valuation of Corporate Reputation

and Poor's 500. Antunovich and Laster (1999) nd that a portfolio of the top decile of Fortune's most-admired rms earns an abnormal return of 3.2 per cent in the year after the survey is published and 8.3 per cent over three years. We provide an empirical analysis of the value-relevance of one widely known measure of corporate reputation, the annual Fortune survey of America's most admired companies. We examine the value of corporate reputation through use of a model which allows us to determine if corporate reputation is a signicant explanatory component of market value of equity (MV). We take into account the Brown and Perry (1994) nding that there is a nancial performance halo that heavily inuences the list of Fortune's most admired companies and employ a modied form of their methodology, thereby segregating nancial measures (MV, risk and growth) in the Fortune rankings before employing the nal regression model. The Fortune summary measure thus serves as a proxy for an aggregation of non-nancial information, such as internally generated goodwill, customer service, product quality, and intellectual capital. Consequently, our research question represents a convergence of prior studies in a variety of business-related elds such as marketing, management, economics, organizational strategy and accounting that examine corporate reputation. We do this by showing there is nancial value to a successful investment in non-nancial attributes, even though these investments in many cases are impossible to measure nancially. As discussed by Shenkar and YuchtmanYaar (1997), corporate reputation is important in identifying potential partners in joint ventures and potential targets in mergers and acquisitions, in attracting and retaining higher-quality employees, in improving standing with `salient publics'

(Perrow 1961), and in allowing businesses to charge a premium for their goods and services. Drumwright (1996) nds that advertising campaigns with social dimensions are not particularly eective in increasing sales or prots, but are highly eective in achieving company-oriented objectives such as motivating employees or communicating the company's mission. However, few accounting studies have examined whether there is nancial value to an investment in non-nancial attributes. As discussed in Fombrun and van Riel (1997), we recognize that reputations embody appraisals of two dimensions of rm eectiveness the economic performance and the rm's social responsibilities and we provide evidence of the nancial benet to a rm eectively meeting the latter. We nd evidence of value-relevant information provided by the Fortune survey that cannot be explained by nancial information available from nancial reporting sources. The signicance of the non-nancial reputation component provides evidence of an invisible intangible asset that is value-relevant in explaining the market value of the rm and appears to demonstrate the validity of corporate decisions to make reputation-enhancing expenditures. The remainder of this paper is organized as follows. First, we review pertinent research on corporate reputation. We then discuss research methodology, provide results of the study, and present concluding remarks.
LITERATURE REVIEW Tangible assets, as well as some classes of intangible assets (eg, patents and trademarks), can be easily transferred, thereby allowing valuation through an arms' length transaction. Corporate reputation, an intangible asset that is developed internally for the most part and that is not easily transferable to other parties, does not lend

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itself to such easily determinable valuation. Reputation-building, though, appears to be valuable to rms. Reputations represent publics' cumulative judgments of rms over time, according to Fombrun and Shanley (1990), who conclude that these judgments `stratify industries, with potentially signicant competitive advantages accruing to rms with higher perceived reputational status.' They theorize that conditions of incomplete and ambiguous information and heterogeneous publics make reputations relevant, and they nd that rms compete for reputation in such a market. They study the 292 rms included in the 1985 Fortune survey and nd that assessments of reputation appear to be positively related to prior accounting protability, advertising intensity, and size, and negatively related to prior performanceadjusted risk. The importance of nancial information, such as accounting protability and risk, on the Fortune measure implies that there exists a nancial performance halo in the magazine's index of corporate reputation. Since individual raters appear to be so heavily inuenced by previous nancial performance, previous attempts to determine the relationship between specic attributes of corporate reputation and rm value may be victimized by a circularity rm value improves reputation which improves rm value ad innitum. Brown and Perry (1994) develop a statistical method to remove a signicant portion of that halo in order to alleviate the perceptual distortion it adds to the data. After forming a halo index based upon various measures of recent nancial performance, they determine rm-specic residuals that represent the portion of the Fortune ratings not explained by nancial performance. They apply this method to the rms in the 1992 Fortune survey and validate their results by comparing the halo-removed rating on four specic attributes (eg, product quality or innovation) to

independent evaluations of corporate performance on similar attributes. They conclude their method is especially valuable for researchers using Fortune's ratings to test `the impact of (non-nancial) attributes on corporate nancial performance or stock market returns.' Shefrin and Statman (1995, 1998) hypothesize that rms rated highly with the Fortune measure will underperform the market, since the survey typically gives high ratings to rms with high market-tobook ratios and large market capitalization characteristics associated with low stock returns by Fama and French (1992), among others. However, their empirical results provide little support for this hypothesis. Antunovich and Laster (1999) sort rms into seven portfolios based upon their annual Fortune reputation measure and form stock portfolios in order to determine whether abnormal returns are associated with the rankings. They nd that the mostadmired decile signicantly outperforms the least-admired decile for up to ve years after the survey and conclude that their ndings are an example of investors underreacting to publicly available information. Empirical investigations of limited aspects of corporate reputation have been undertaken by Ittner and Larcker (1998), Beatty and Ritter (1986), McGuire, Sundgren and Schneeweis (1988), and McGuire, Schneeweis and Branch (1990). Ittner and Larcker examine the value relevance of customer satisfaction in order to determine whether measures of satisfaction are leading indicators of accounting performance and whether the release of such measures provides new or incremental information to the stock market. Their study includes customer service measures at three levels: (1) a study of 2,491 customers buying a specic telecommunications service from a single rm

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(2) a business-unit analysis of customer satisfaction from 73 retail branch banks of a major US nancial services provider (3) rm-level data from the American Customer Satisfaction Index. They nd the relationships between customer satisfaction and future accounting performance generally are positive, but some are non-linear, showing evidence of diminishing benets at high levels of satisfaction. They also nd that public release of these measures is statistically associated with excess stock market returns. Beatty and Ritter (1986) examine the underpricing of initial public oerings and nd that it is related to the reputational capital of investment bankers. They conclude that investment bankers have nonsalvageable reputational capital at stake, and this enforces the underpricing equilibrium, as they show the market penalizes underwriters who cheat on this equilibrium by underpricing too much or too little. McGuire, Sundgren and Schneeweis (1988), using Fortune's ratings as a proxy for corporate social responsibility, nd that perceptions of social responsibility are more closely associated with prior nancial performance than with subsequent nancial performance. These results may reect the `halo eect' referred to by Brown and Perry (1994), as the authors fail to control for the inuence nancial variables have upon the Fortune reputation measure. McGuire, Schneeweis and Branch (1990) extend these results to all eight dimensions of perceived rm performance contained in the Fortune measure and nd that high returns (both return on assets and market returns) are highly correlated with subsequently high rm image the `halo eect' of Brown and Perry (1994). However, they nd that the Fortune metric `has little value as a forecaster of future rm nancial performance.'

Our research extends the existing literature by undertaking an explicit search for market eects of nonnancial factors aecting corporate reputation. We employ the Fortune `America's most admired corporations' summary reputation measure, thereby investigating a broader denition of reputation than the specic aspect studied by Ittner and Larcker (1998). By applying a variation of the model developed by Brown and Perry (1994), we remove the `halo eect' of nancial performance and isolate the other inuences upon the Fortune rankings in order to extend the research of McGuire, Sundgren and Schneeweis (1988), McGuire, Schneeweis and Branch (1990), Shefrin and Statman (1995, 1998) and Antunovich and Laster (1999).
METHODOLOGY The market value of equity expectation of the expected ows (CF) accruing to discounted at the appropriate rate r:

(MV) is the future cash stockholders risk-adjusted

MVt = ~(1 + rt)1 Et[CFt]

t=0

(1)

MV can be disaggregated into the market value of assets and liabilities. A commonly used proxy for the market value of assets and liabilities is the book value of assets and liabilities. However, due to conservatism, historical costs, and the exclusion of most intangible assets, accounting book values are unlikely to capture completely the implications of their market value counterparts. Therefore, Equation 1 becomes: MVt = Assetst Liabilitiest + Intangible Assetst (2) where intangible assets represent, for example, the discounted cash ows accruing to shareholders due to reputation

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eects, competitive advantages, anticipated growth opportunities, or positive net present value projects. Fortune annually provides a reputation summary measure of America's largest corporations in its `America's most admired corporations' issue. Brown and Perry (1994) nd that this rating, which is a measure of the rm's competitive advantage and reputation, is heavily inuenced by the rm's previous nancial results, thus creating a `halo eect.' This eect must be removed, or controlled for, before these qualitative reputational measures can be used appropriately in this study to measure the value relevance of the intangible asset unexplained by nancial reporting data. Brown and Perry nd several nancial factors that aect the Fortune summary measure (SCORE): return on assets (ROA), market-to-book value (MKTBV), size, growth, and risk. Adding in dummy variables for each year to control for other economic eects yields Equation 3: SCOREt = a0 + ~ DMYy + a1ROAt + a2MKTBVt + a3SIZEt + a4BETAt + (3) a5GROWTHt + et where: SCOREt = Corporate reputation Score in year t taken from Fortune magazine annual reputation survey. = (Income Before Extraordinary Items Deated by Total Assets) *100 in year t. = Market Value of Common Equity Deated By Book Value of Common Equity at the end of year t. = the natural log of the Market Value of Common Equity in year t.
y=82 96

= Market Model Beta computed as 5-year (60month) time period, ending at the end of year t (as computed by Compustat). GROWTHt = (Sales t-5 Salest)/ Salest. The residuals and estimated coecients from this model are used to test the valuerelevance of the nonnancial factors (the invisible assets) represented by the SCORE. The estimated coecients are used to calculate a predicted reputation score which measures the portion of the Fortune rating score that nancial statement users can obtain from nancial performance data. The residuals from estimating Equation 3 represent the intangible assets related to reputation eects that a rm has which cannot be obtained through the analysis of the nancial statements and market data. We use a valuation model (used by Burgstahler and Dichev 1997 and Barth, Beaver and Landsman, 1998) that expresses, in general form, market value of equity (MV) for rm i in year t, as a linear function of recognized net assets in place (BV) and unrecognized net assets, UNA: MVit = a1BVit + a2UNAit (4)

BETAt

ROAt

MKTBVt

SIZEt

If book values of recognized assets equal their fair values and fair values are welldened as in a setting economically equivalent to perfect and complete markets, UNA equals the present value of incremental cash ows of unrecognized net assets and a1 and a2 each equal one. If book values do not equal their fair values, then UNA also includes the dierence between fair and book values of recognized net assets; ie, it would include the dierence in the fair and book values of assets and the value of the intangibles, such as market reputation. Thus, in the more realistic

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setting of imperfect and incomplete markets, UNA reects the dierence between assets' values-in-use over entry or exit values, and a1 and a2 need not equal one. Because revenues and expenses relating to unrecognized net assets, including any excess of values-in-use over entry or exit values, can be reected in net income (NI), net income is a proxy for UNA (see Bernard 1994; Barth and Landsman 1995, and Ohlson 1995). We modify Equation 4 to control for annual eects and to include a measure of intangible assets by including the non-nancial factors estimated from Equation 3. This measure of the market reputation of the company that is beyond what can be determined by nancial factors is a proxy for the value of corporate reputation not measured in the accounting measure of the book value of net assets or common equity. Thus, our estimating equation becomes: MVt = b0 + ~ DMYy + b1BVt + b2NIt + b3NonFREPt1 + SIZEt + nt (5) where, MVt = Market Value of Common Equity at year t = Annual year dummy variDMYy ables set equal for 1 if t = y; 0 otherwise. = Book Value of Common BVt Equity at year t = Net Income Before ExtraNIt ordinary Items at year t NonFREPt1 = Non-nancial Component of Corporate Reputation derived by taking the residual value from the estimation of rm reputation in Equation 3. = A control for size, measured SIZEt as total assets at year t.
y=82 96

The value-relevance of the nonnancial component of corporate reputation, NonFREP, is estimated in Equation 5. We use market value of equity at the end of the year t as the dependent variable. It is expected that the market will have impounded all current and past information into this value. The Fortune survey results are published early in year t, but apply to the survey taken during t-1. Thus, if the intangible asset component of the survey results is value-relevant, NonFREP should be signicant. From the previous discussion we expect this to be true; therefore, our main hypothesis becomes: H: We expect that the non-nancial component of the Fortune summary measure is value relevant, ie, that the coecient on NonFREP will be signicant and positive.
Sample selection The sample consists of all of the rms rated by Fortune magazine in the 1982 through 1996 `America's most admired corporations' rating published early each of the following years. For each year included in the sample, Fortune sought ratings of corporate excellence from several thousand top executives, outside directors, and securities analysts. These experts were asked to rate the ten largest rms (measured by sales) in their own industry or economic sector, comparing them to competitors with respect to eight key attributes of reputation: innovativeness, quality of management, employee talent, quality of products/services, long-term investment value, nancial soundness, social responsibility, and use of corporate assets. The ratings are on a zero (poor) to ten (excellent) scale. Fortune typically gets a response rate of about 50 per cent to its survey, and it publishes the results every March. In addition to the Fortune rating, we obtained other nancial data from Compustat PCPlus. These sample selection criteria

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result in a sample size of 2,905 rm-year observations for Equation 3 and 2,769 rm-year observations for estimation of Equation 5.
RESULTS We rst estimate Equation 3 in order to control for the `halo eect' described by Brown and Perry (1994). Each of the variables in Equation 3 is statistically signicant, with signs the same as found by Brown and Perry. Descriptive statistics for the variables used in estimating Equation 3 are found in Table 1. The residuals from Equation 3, which represent the nonnancial reputation component, are saved for use in Equation 5. Coecients for the estimation of Equation 2 are found in Table 2. The mean of these residuals, as expected, is equal to 0.1

We then estimate Equation 5 in order to determine whether the non-nancial reputation component of the Fortune survey is incrementally value-relevant once we control for the nancial information. In the rst column of Table 4, results of the estimation of Equation 5 are reported. Non-nancial components of the Fortune reputation score are incrementally valuerelevant at p=.001, as are BV and income. The signicant positive coecient on the non-nancial components (NonFREP) provides evidence that information provided by the Fortune survey is value relevant beyond what is provided by nancial information available from nancial reporting sources. This non-nancial reputation component is evidence of an invisible intangible asset that is valuerelevant in explaining the market value of the rm.

Table 1: Descriptive statistics for rms used in Equation 3

Variable SCOREt ROAt MKTBVt SIZEt BETAt GROWTHt Mean 6.445 4.824 2.597 8.072 0.905 65.2244 Median 6.480 4.840 1.999 8.086 0.881 42.029 Std. Deviation 0.881 5.776 3.777 1.395 0.401 194.007

N = 2,905 Firm-year observations Denition of Variables: = Corporate reputation Score in year t taken from SCOREt Fortune Magazine Annual Reputation Survey. = (Income Before Extraordinary Items Deated by ROAt Total Assets) *100 in year t. MKTBVt = Market Value of Common Equity Deated By Book Value of Common Equity in year t. = the natural log of the Market Value of Common SIZEt Equity in year t. = Market Model Beta computed as 5-year (60-month) BETAt time period, ending at the end of year t (as computed by Compustat). GROWTHt = (Sales t-5 Salest)/Salest.

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Table 2: Estimation of fortune reputation score

Score0 = a0 + a1ROAt + a2 MKTBVt + a3SIZEt + a4BETAt + a5GROWTHt+ et Variable Constant ROAt MKTBVt SIZEt BETAt GROWTHt Coecient 4.106 0.058 0.012 0.245 0.086 0.024 (3)

T-statistic 6.480 23.471 3.390 24.367 2.663 3.665

Adjusted R2: 39.82% F=107.732 Note: Statistically signicant annual dummy variables are estimated (not reported) over pooled cross-section samples of rm data. Denition of Regression Variables: = Corporate reputation Score in year t taken from SCOREt Fortune Magazine Annual Reputation Survey. = (Income Before Extraordinary Items Deated by ROAt Total Assets) *100 in year t. MKTBVt = Market Value of Common Equity Deated By Book Value of Common Equity in year t. = the natural log of the Market Value of Common SIZEt Equity in year t. = Market Model Beta computed as 5-year (60-month) BETAt time period, ending at the end of year t (as computed by Compustat). GROWTHt = (Sales t-5 Salest)/Salest.

As a form of sensitivity analysis, we test Equation 5 using various combinations of the independent variables. These results also are reported in Table 4. The second column contains the results of the basic model (Equation 4), omitting any variables related to reputation. As expected, both book value and income have signicant positive coecients. When the reputation score from Fortune is included in the model, its coecient is signicant and positive (see column 3, Table 4), indicating that the score is incrementally value-relevant beyond income and book value. We also nd that the nonnancial component of reputation,

NonFREP, continues to be positive and signicant (see column 4 of Table 4) even when the nancial component of reputation is included.2 We also note the increase in the adjusted R2 from 74.9 per cent to 76.2 per cent when the reputation score, SCOREt-1, is disaggregated between the non-nancial and nancial components (see columns 3 and 4 of Table 4).3 It is also interesting to note the dierent coecients and valuations given to a one-point change in score ($2.052bn in column 3) versus a one-point change in the non-nancial component and nancial components ($1.015bn and $4.137bn, respectively, in column 4).

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Table 3: Descriptive statistics for variables used in market value model

Variable MVt BVt INCOMEt SCOREt-1 NonFREPt-1 FREPt-1 Mean 6702.344 3261.155 458.549 6.445 0.000 6.446 Median 2974.555 1623.376 206.443 6.480 0.041 6.470 Std. Deviation 10983.647 4978.992 894.561 0.881 0.684 0.561

N= 2,769 Firm-year Observations Denition of Variables: = Market Value of Common Equity at year t. MVt = Book Value of Common Equity at year t. BVt = Net Income Before Extraordinary Items at year t. NIt NonFREPt-1 = Nonnancial Component of Corporate reputation derived by taking the residual value from the estimation of rm reputation in Equation 3. = Financial Component of Corporate reputation derived FREPt-1 by taking the residual value from the estimation of rm reputation in Equation 3. SCOREt-1 = Corporate reputation Score in year t taken from Fortune Magazine Annual Reputation Survey.

CONCLUSIONS An important asset of the rm is its corporate reputation. Such factors as internally generated goodwill are the result of past reputation-enhancing activities and must be constantly maintained. We provide evidence of the market's ability to value this invisible intangible asset, using the annual Fortune survey of `America's most admired companies,' even after controlling for the portion of the Fortune ranking explained by nancial reporting information. Our ndings add support to existing research that internally generated intangibles not currently recognized as assets contribute to rm value and thus are viewed as assets by investors. These ndings have implications for external accounting reporting, as many critics of generally accepted accounting principles, such as Edvinsson and Malone

(1997), decry the failure of nancial statements to value many intangible assets that are critically important to modern corporations. Our demonstration that one widelypublicized summary measure of such intangible assets is highly correlated with market value even after controlling for nancial performance provides further evidence of the relevance of non-GAAP measures of rm-specic information. This provides support for IASC Statement No. 38, `Intangible Assets' and for the position of the American Accounting Associations Financial Accounting Standards Committee (1998). We also provide evidence to support the conclusions of such authors as Fombrun and van Riel (1997) and Shenkar and Yuchtman-Yaar (1997) that reputations are valuable rm assets. A valid question for the inclusion of corporate reputation as an intangible asset

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Table 4: Market valuation of non-nancial components of corporate reputation (Equation 5)

MVt = b0 + ~ DMYy + b1BVt + b2N1tb3NonFREPt1 + b4SIZEt + nt
y=82 96

Coecient (t-statistic) Constant BVt NIt NonFREPt-1 FREPt-1 SCOREt-1 SIZEt N F-statistic Adj. R
2

Coecient (t-statistic) 1522.05 (4.20) 1.16 (31.74) 5.16 (27.17)

Coecient (t-statistic) 11363.43 (12.73) 1.12 (31.83) 4.57 (24.63)

Coecient (t-statistic) 25841.24 (17.60) 1.08 (30.92) 4.00 (21.19) 1015.03 (6.41) 4368.67 (19.16)

1510.40 (4.10) 1.16 (31.51) 5.12 (26.73) 998.80 (5.91)

2051.59 (15.67) .03 (6.29) 2769 427.43 72.9% .03 (6.35) 2769 462.42 72.7% .02 (4.86) 2769 488.30 74.9% .02 (3.40) 2769 479.43 76.2%

Denition of Regression Variables: = Market Value of Common Equity at year t. MVt BVt = Book Value of Common Equity at year t. = Net Income Before Extraordinary Items at year t. NIt NonFREPt-1 = Nonnancial Component of Corporate reputation derived by taking the residual value from the estimation of rm reputation in Equation 3. = Financial Component of Corporate reputation derived by taking the residual FREPt-1 value from the estimation of rm reputation in Equation 3. SCOREt-1 = Corporate reputation Score in year t taken from Fortune Magazine Annual Reputation Survey. = Total assets in year t. SIZEt Variables for which no coecient was reported were not considered in that version of Equation 5.

in the nancial statement continues to be the recognition criteria. While we provide some evidence on the relative worth of an incremental increase in corporate reputation, we do not provide a method for evaluating and measuring, in dollar terms, an individual rm's reputation. However, a

rm could choose to disclose non-nancial factors related to its internally generated intangible assets in the Management Discussion and Analysis section of the annual report, or in other ways that are appropriate. Avenues for future research include

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isolation and valuation of specic factors aecting corporate reputation in order to determine which nonnancial information is more value-relevant to the markets and investigation of the market eects of shifts in reputation. The longevity, or permanence, of these assets is also an area of interest to researchers, managers, and investors.
ACKNOWLEDGMENT The authors would like to thank Mark Hirschey, Jim Guthrie and Kelly Welch at the University of Kansas, participants at the Central States Accounting Workshop, and workshop participants at the University of Arkansas for their helpful comments on an earlier version of this paper.
1 We also ranked the residuals and used the ranking rather than the residual, with no qualitative eect upon the results. 2 It is possible that corporate reputation varies by industry. As a test of robustness, we include industry dummy variables in the estimation of models 3 and 5 and nd similar results. As another test of robustness, we control for the possible endogeneity between market value and the estimation of the Fortune reputation score by estimating the incremental market valuation of the nancial (FREPt1) and non-nancial components of reputation (NonFrept1) to still be positive and signicant. 3 As an additional control for size, we converted all our data to z-scores and performed the analysis using these scores. The tenor of the reported results was not changed.

ENDNOTES

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