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Home > Business Strategy Best Practice > The Cost of Reputation: The Impact of Events on a Company’s Financial Performance

Business Strategy Best Practice

The Cost of Reputation: The Impact of Events on a Company’s Financial Performance

by Daniel Diermeier

This Chapter Covers

  • Reputational crises have a significant impact on a company’s valuation.

  • They can be triggered by any business activity and do not necessarily reflect lapses in a company’s ethics or integrity.

  • Both the frequency and the magnitude of such events is increasing.

  • The underlying factors that drive these developments are likely to increase in importance.

  • Since reputational risk cannot be hedged or “outsourced,” companies need to develop effective reputation management capabilities.

  • Such capabilities consist of an integrated reputation management system and its core components: (1) mindset, (2) processes, and (3) values and culture.

  • A reputation management process consists of a decision-making system and an intelligence system.

Introduction

CEOs and board members routinely list reputation as one the company’s most valuable assets. Yet every month a new reputational disaster makes the headlines, destroying shareholder value and trust with customers and other stakeholders. During the last year, leading companies such as Toyota, Goldman Sachs, BP, Johnson & Johnson, and HP battled severe reputational crises. In all cases, financial markets punished the companies, leading to a severe and sustained erosion of their market values. In many cases, reputational damage is followed by lawsuits, public hearings, investigations, and regulatory actions.

In contrast to the scandals related to Enron, WorldCom, and Arthur Andersen a decade earlier, these crises are not limited to a specific domain (accounting practices and standards, especially with “new economy” firms) or caused by a dramatic increase in blatantly unethical or illegal activities. Rather, the involved companies were all category leaders, some with iconic status in their respective industries, and the issues involved ranged from quality and safety to disclosure and (alleged) executive misconduct.

The increase in the frequency and impact of reputational issues suggests that more fundamental shifts are occurring in the business environment and that companies are unprepared for dealing with them. What companies lack is an effective reputation management capability in the presence of increasing reputational risk. Too often, reputation management is considered a (sub)function of corporate communication and isolated from business decisions. Rather, companies need to adopt a strategic approach that treats reputational challenges as understandable and even predictable. As a result, companies should manage their reputation like any other major business challenge: based on principled leadership and supported by sophisticated processes and capabilities that are integrated with the company’s business strategy and culture.

Case Study

Bausch & Lomb

Markets do not always properly adjust to reputational risk. One such example is Bausch & Lomb, a producer of soft contact lenses and lens care products. On April 10, 2006, the US Centers for Disease Control and Prevention linked a surge in potentially blinding fungal infections with Bausch & Lomb’s new ReNu contact lens solution. As a result, Bausch & Lomb’s stock price dropped from a closing price of US$57.67 on Friday, April 7, to US$45.61 on Wednesday, April 12. The company was heavily criticized for its handling of the crisis and the depressed stock price persisted. Bausch & Lomb subsequently experienced accounting restatements and was acquired by the private equity firm Warburg Pincus.

Remarkably, the link between the infections and ReNu, however, had been uncovered almost two months earlier, on February 22, in a public announcement by Singapore’s Ministry of Health. (Bausch & Lomb subsequently withdrew the ReNu solution from its markets in Singapore and Hong Kong). The government announcement had been reported in the region’s major newspapers, but had not been covered in the United States. Bausch & Lomb’s stock lost a mere 3% from a closing price of US$71.51 on February 21 to US$69.40 on February 23, and quickly recovered. In other words, financial markets ignored the early warning signs.

The Cost of Reputational Crises

Severe erosion of shareholder value is common during reputational crises. During its recent crisis triggered by the sudden acceleration issue, Toyota’s stock price dropped by as much as 24%, wiping out about US$33 billion in shareholder value, close to the total market value of Time Warner. In its battle with the US government in the aftermath of the 2008–09 financial crisis, Goldman Sachs lost US$24 billion of its market capitalization, a 26% drop in share price that exceeded the entire value of American Express. During the BP oil spill disaster in the Gulf of Mexico, BP’s stock was almost cut in half, the equivalent of about US$90 billion in shareholder value, more than the market value of Procter & Gamble.

In some cases the drop in stock value is temporary, in other cases permanent. Much depends on how the companies handle the aftermath of crisis and commit to fixing the underlying business issue rather than engaging in shallow PR exercises. Toyota, for example, commenced a global quality improvement initiative that involved cultural and process changes at every level of the company.

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Further reading

Book:

  • Diermeier, Daniel. Reputation Rules: Strategies for Building Your Company’s Most Valuable Asset. New York: McGraw-Hill, 2011.

Articles:

  • Minor, Dylan. “CSR as reputation insurance: Theory and evidence.” Working paper. Kellogg School of Management, 2010.
  • Roberts, Peter W., and Grahame R. Dowling. “Corporate reputation and sustained superior financial performance.” Strategic Management Journal 23:12 (December 2002): 1077-1093. Online at: dx.doi.org/10.1002/smj.274
  • Uhlmann, Eric Luis, George E. Newman, Victoria Medvec, Adam Galinsky, and Daniel Diermeier. “The sound of silence: Corporate crisis communication and its effects on consumer attitudes and behavior.” Working paper. Kellogg School of Management, 2010. Online at: tinyurl.com/3n89y65 [PDF].

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