THE MARKET VALUATION OF FIRM REPUTATION

ERVIN L. BLACK*
THOMAS A. CARNES*
VERNON J. RICHARDSON**
April 1999

*Assistant Professors, Department of Accounting, University of Arkansas,

Fayetteville, AR 72701
**Assistant Professor, Division of Accounting and Information Systems,
University of Kansas, Lawrence, KS 66045
Please direct all correspondence to Thomas A. Carnes at the above address,
(501) 575-4117, carnes@comp.uark.edu.

The authors would like to thank Mark Hirschey, Jim Guthrie and Kelly Welch at
the University of Kansas and participants at the Central States Accounting
Workshop for their helpful comments on an earlier version of this paper.

THE MARKET VALUATION OF FIRM REPUTATION

Abstract
We show that the intangible asset firm reputation has value relevance, as
measured by its ability to explain part of the difference between book value and market
value of equity. Firm reputation is measured using the Fortune survey of Americas
most admired companies. We allow the Fortune rankings to serve as a proxy for
nonfinancial information, such as customer service and intellectual capital. We
demonstrate this summary measure of nonfinancial information adds to market value,
even after controlling for the financial performance halo effects on the Fortune ratings.

THE MARKET VALUATION OF FIRM REPUTATION

Measurements of firm reputation appear nowhere in the financial
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 benefits
to the corporation. The benefits may not always be financial in a direct sense
(e.g., 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 firm-specific financial benefits to corporations by
reducing the mobility of industry rivals (Caves and Porter, 1977; Wilson, 1985);
by allowing firms to charge premium prices (Klein and Leffler, 1981; Milgrom and
Roberts, 1986); or by enhancing firm 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, firms signal
their key characteristics to constituents (Fombrun and Shanley, 1990). Firm
reputation therefore meets the customary accounting definition of an intangible
asset, though it is not one that is specifically identifiable (in contrast to a patent or
trademark). Instead, it is a qualitative asset, and the determination and timing of
its future benefits to the firm are extremely difficult to quantify, thereby posing
serious valuation problems. Edvinsson and Malone (1997) refer to such assets
as invisible assets.
Despite the difficulty in quantifying the worth of a favorable firm reputation,
it should have value to the investor since it results in financial benefits 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 indefinitely,
converting to line items on the balance sheet years after the market has
accounted for them. There is anecdotal evidence regarding the value-relevance
of firm 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 and Poors 500.
We provide an empirical analysis of the value-relevance of one widely
known measure of firm reputation, the annual Fortune survey of Americas most
admired companies. We examine the value of firm reputation through use of the
Ohlson model (1995), which allows us to determine if firm reputation is a
significant explanatory component of market value of equity (MV). We take into
account the Brown and Perry (1994) finding that there is a financial performance
halo that heavily influences the list of Fortunes most admired companies and
employ a modified form of their methodology, thereby segregating financial
measures (MV, risk and growth) in the Fortune rankings before employing the
Ohlson model. This allows the Fortune rankings to serve as a proxy for an
aggregation of nonfinancial information, such as customer service, product
quality, and intellectual capital.
We find evidence of value-relevant information provided by the Fortune
survey that cannot be explained by financial information available from financial
reporting sources. This non-financial reputation component is evidence of an

invisible intangible asset that is value-relevant in explaining the market value of

the firm 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 firm 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 (e.g.,
patents and trademarks), can be easily transferred, thereby allowing valuation
through an arms length transaction. Firm reputation, an intangible asset that is
developed internally for the most part and that is not easily transferable to other
parties, does not lend itself to such easily determinable valuation.
Reputation-building, though, appears to be valuable to firms. Reputations
represent publics cumulative judgments of firms over time, according to
Fombrun and Shanley (1990), who conclude that these judgments stratify
industries, with potentially significant competitive advantages accruing to firm
with higher perceived reputational status. They theorize that conditions of
incomplete and ambiguous information and heterogeneous publics make
reputations relevant, and they find that firms compete for reputation in such a
market. They study the 292 firms included in the 1985 Fortune survey and find
that assessments of reputation appear to be positively related to prior accounting
profitability, advertising intensity, and size, and negatively related to prior
performance-adjusted risk.

The importance of financial information, such as accounting profitability

and risk, to the Fortune rankings means that there exists a financial performance
halo in the magazines index of firm reputation. Since individual raters appear to
be so heavily influenced by previous financial performance, previous attempts to
determine the relationship between specific attributes of firm reputation and firm
value may be victimized by a circularity firm value improves reputation which
improves firm value ad infinitum. Brown and Perry (1994) develop a statistical
method to remove a significant 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 financial performance, they determine firm-specific
residuals that represent the portion of the Fortune ratings not explained by
financial performance. They apply this method to the firms in the 1992 Fortune
survey and validate their results by comparing the halo-removed rating on four
specific attributes (e.g., product quality or innovation) to independent evaluations
of corporate performance on similar attributes. They conclude their method is
especially valuable for researchers using Fortunes ratings to test the impact of
(nonfinancial) attributes on corporate financial performance or stock market
returns.
Empirical investigations of limited aspects of firm 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 it 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
specific telecommunications service from a single firm; (2) a business-unit
analysis of customer satisfaction from 73 retail branch banks of a major U.S.
financial services provider; and (3) firm-level data from the American Customer
Satisfaction Index. They find the relationships between customer satisfaction
and future accounting performance generally are positive, but some are nonlinear, showing evidence of diminishing benefits at high levels of satisfaction.
They also find that public release of these measures is statistically associated
with excess stock market returns.
Beatty and Ritter (1986) examine the underpricing of initial public offerings
and find that it is related to the reputational capital of investment bankers. They
conclude that investment bankers have non-salvageable 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 Fortunes ratings as a
proxy for corporate social responsibility, find that perceptions of social
responsibility are more closely associated with prior financial performance than
with subsequent financial performance. These results may reflect the halo
effect referred to by Brown and Perry (1994), as the authors fail to control for the
influence financial variables have upon the Fortune rankings. McGuire,

Schneeweis and Branch (1990) extend these results to all eight dimensions of
perceived firm performance contained in the Fortune rankings and find that high
returns (both return on assets and market returns) are highly correlated with
subsequently high firm image the halo effect of Brown and Perry (1994).
However, they find that the Fortune rankings have little value as a forecaster of
future firm financial performance.
Our research extends the existing literature by undertaking an explicit
search for market effects of nonfinancial factors affecting firm reputation. We
employ the Fortune Americas most admired corporations rankings, thereby
investigating a broader definition of reputation than the specific aspect studied by
Ittner and Larcker (1998). By applying a variation of the model developed by
Brown and Perry (1994), we remove the halo effect of financial performance
and isolate the other influences upon the Fortune rankings in order to extend the
research of McGuire, Sundgren and Schneeweis (1988), and McGuire,
Schneeweis and Branch (1990).
METHODOLOGY
The market value of equity (MV) is the expectation of the expected future
cash flows (CF) accruing to stockholders discounted at the appropriate riskadjusted rate r:

MV =
t

(1 + r ) t Et =0 [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 flows
accruing to shareholders due to a competitive advantage, an anticipated growth
opportunity, or positive net present value projects.
Fortune annually rates Americas largest corporations in its Americas
most admired corporations issue. Brown and Perry (1994) find that this rating,
which is a measure of the firms competitive advantage, is heavily influenced by
the firms previous financial results, thus creating a halo effect. This effect 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 financial reporting data. Brown and Perry find
several financial factors that affect the Fortune rating score (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 effects yields
equation 3.

SCORE t = a 0 +

96

DMY y + a1 ROAt + a 2 MKTBVt + a 3 SIZE t + a 4 BETAt + a5 GROWTH t + t

y =82

(3)
where:
SCOREt

= Firm Reputation Score in year t taken from Fortune magazine

annual reputation survey.

ROAt

= (Income Before Extraordinary Items Deflated by Total Assets) *100

in year t.

MKTBVt

= Market Value of Common Equity Deflated By Book Value of

Common Equity at the end of year t.

SIZEt

= the natural log of the Market Value of Common Equity in year t

BETAt

= Market Model Beta computed as 5-year (60-month) time period,

ending at the end of year t (as computed by Compustat).

GROWTHt = (Sales t-5 Salest)/ Salest .

The residuals and estimated coefficients from this model are used to test
the value-relevance of the nonfinancial factors (the invisible assets). The
estimated coefficients are used to calculate a predicted reputation score which
measures the portion of the Fortune rating score that financial statement users
can obtain from financial performance data. The residuals from estimating
equation 3 represent the intangible assets related to reputation effects that a firm
has which cannot be obtained through the analysis of the financial statements
and market data.

Ohlson (1995) develops the following market valuation model, assuming

clean surplus accounting:
MVt = BVt + NI t

(4)
where,
MVt = the market value of equity at time t.
BVt = the book value of equity at time t.
NIt = net income at time t.
Modifying this equation to control for annual effects and to allow for the
measure of intangible assets including the nonfinancial factors estimated from
equation 3 yields:

MVt = b0 +

96

DMYy + b1BVt + b2 NI t + b3 NonFREPt 1 + vt

y = 82

(5)
where,
MVt

Market Value of Common Equity at year t

DMYy

Annual year dummy variables set equal for 1 if t = y; 0

otherwise.

BVt

Book Value of Common Equity at year t

NIt

Net Income Before Extraordinary Items at year t

NonFREPt-1 =

Nonfinancial Component of Firm Reputation derived by

taking the residual value from the estimation of firm
reputation in equation 3.

10

The value-relevance of the nonfinancial component of firm 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 survey results are value-relevant, NonFREP should be significant.
Sample Selection
The sample consists of all of the firms rated by Fortune magazine in the
1982 through 1996 Americas 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
firms 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, financial soundness, social responsibility, and use of corporate assets.
Fortune typically gets a response rate of about 50 percent to its survey, and it
publishes the results every March. In addition to the Fortune rating, we obtained
other financial data from Compustat PCPlus. These sample selection criteria
result in a sample size of 2,905 firm-year observations for equation 3 and 2,881
firm-year observations for estimation of equation 5.

11

RESULTS
We first estimate equation 3 in order to control for the halo effect
described by Brown and Perry (1994). Each of the variables in equation 3 is
statistically significant, 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.
Insert Table 1 about here

The residuals from equation 3, which represent the nonfinancial reputation

component, are saved for use in equation 5. Coefficients for the estimation of
equation 2 are found in Table 2. The mean of these residuals, as expected, is
equal to 0.1
Insert Table 2 about here

We then estimate equation 5 in order to determine whether the

nonfinancial reputation component of the Fortune survey is incrementally valuerelevant once we control for the financial information. Descriptive statistics for
variables used to estimate equation 5 are found in Table 3.

Insert Table 3 about here

12

In column 3, Table 4, results of the estimation of equation 5 are reported.

Nonfinancial components of the Fortune reputation score are incrementally
value-relevant at p=.001, as are BV and income. The significant positive
coefficient on the nonfinancial components (NonFREP) provides evidence that
information provided by the Fortune survey that cannot be explained by financial
information available from financial reporting sources is value-relevant. This
nonfinancial reputation component is evidence of an invisible intangible asset
that is value-relevant in explaining the market value of the firm.
Insert Table 4 about here

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 first column contains the results of the Ohlson model (equation 4),
omitting any variables related to reputation. As expected, both book value and
income have significant positive coefficients.
When the rating score from Fortune is added to the Ohlson model, its
coefficient is significant and positive (see column 2 of Table 4), indicating that the
score is incrementally value-relevant beyond income and book value. We also
find that the nonfinancial component of reputation, NONFREP, continues to be
positive and significant (see column 4 of Table 4) even when the financial
component of reputation is included.2
We also note the increase in the adjusted R2 from 74.2% to 75.41% when
the reputation score, SCOREt-1, is disaggregated between the nonfinancial and

13

financial components (see columns 2 and 4 of Table 4). It also interesting to

note the different coefficients and valuations given to a one-point change in score
($2.063 billion in column 2) versus a one-point change in the nonfinancial
component and financial components ($1.081 billion and $4.171 billion in column
4 respectively).
CONCLUSIONS
An important asset of the firm is its internally generated goodwill. Such
goodwill is the result of past reputation-enhancing activities and must be
constantly maintained. We provide evidence of the markets ability to value this
invisible intangible asset, using the annual Fortune survey of Americas most
admired companies, even after controlling for the portion of the Fortune ranking
explained by financial reporting information. Our findings add support to existing
research that internally generated intangibles not currently recognized as assets
contribute to firm value and thus are viewed as assets by investors.
These findings have implications for external reporting, as many critics of
generally accepted accounting principles, such as Edvinsson and Malone (1997),
decry the failure of financial 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 financial performance provides further
evidence of the relevance of non-GAAP measures of firm-specific information.
This provides support for IASC Statement No. 38, Intangible Assets and for the

14

position of the American Accounting Associations Financial Accounting

Standards Committee (1998).
A valid question for the inclusion of firm reputation as an intangible asset
in the financial statement continues to be the recognition criteria. While we
provide some evidence on the relative worth of an incremental increase in firm
reputation we do not provide a method for evaluating an individual firms
reputation. Avenues for future research include isolation and valuation of specific
factors affecting firm reputation in order to determine which nonfinancial
information is more value-relevant to the markets and investigation of the market
effects of shifts in reputation.

15

REFERENCES

Beatty, R.P., and J.R. Ritter. 1986. Investment banking, reputation, and
underpricing of initial public offerings. Journal of Financial Economics, 15: 213232.
Brown, B., and S. Perry 1994. Removing the financial performance halo
from Fortunes Most Admired Companies. Academy of Management Journal,
37: 1347-1359.
Caves, R.E., and M.E. Porter. 1977. From entry barriers to mobility
barriers. Quarterly Journal of Economics, 91: 421-434.
Edvinsson, L., and M.S. Malone. 1997. Intellectual capital: Realizing your
companys true value by finding its hidden brainpower. New York:
HarperBusiness.
Fombrun, C., and M. Shanley. 1990. Whats in a name? Reputation
building and corporate strategy. Academy of Management Journal, 33: 233-258.
Ittner, C.D., and D.F. Larcker. 1998. Are nonfinancial measures leading
indicators of financial performance? An analysis of customer satisfaction.
Journal of Accounting Research, Supplement: 1-35.
Lindsmeier, T., J. Boatsman, R. Herz, R. Jennings, G. Jonas, M. Lang, K.
Petroni, D. Shores, and J. Wahlen. 1998. American Accounting Associations
Financial Accounting Standards Committee Response to IASC Exposure Draft
E60, Intangible Assets. Accounting Horizons, 12: 312-316.
McGuire, J., T. Schneeweis, and B. Branch. 1990. Perceptions of firm
quality: A cause or result of firm performance? Journal of Management, 16: 167180.
McGuire, J., A. Sundgren, and T. Schneeweis. 1988. Corporate social
responsibility and firm financial performance. Academy of Management Journal,
31: 854-872.
Milgrom, P., and J. Roberts. 1986. Relying on the information of
interested parties. Rand Journal of Economics, 17: 18-32.
Ohlson, J.A. 1995. Earnings, Book Values and Dividends in Security
Valuation. Contemporary Accounting Research, 11: 661-687.

16

Stewart, T.A. 1998. Americas Most Admired Companies. Fortune,

137(4): 70-82.
Wilson, R. 1985. Reputations in games and markets. In Game-theoretic
models of bargaining, edited by A. E. Roth, New York: Cambridge University
Press.

17

Table 1
Descriptive Statistics for firms used in Equation 3
Variable

Mean

Median

Std. Deviation

SCOREt

6.445

6.480

0.881

ROAt

4.824

4.840

5.776

MKTBVt

2.597

1.999

3.777

SIZEt

8.072

8.086

1.395

BETAt

0.905

0.881

0.401

GROWTHt

65.224

42.029

194.007

N= 2,905 Firm-year observations

Definition of Variables:
SCOREt

= Firm Reputation Score in year t taken from Fortune Magazine

Annual Reputation Survey.
ROAt
= (Income Before Extraordinary Items Deflated by Total Assets) *100
in
year t.
MKTBVt = Market Value of Common Equity Deflated By Book Value of
Common Equity in year t.
SIZEt
= the natural log of the Market Value of Common Equity in year t
BETAt
= Market Model Beta computed as 5-year (60-month) time period,
ending at the end of year t (as computed by Compustat).
GROWTHt = (Sales t-5 Salest)/ Salest .

18

Table 2
Estimation of Fortune Reputation Score

Score0 = 0 + 1ROAt + 2 MKTBVt + 3SIZEt + 4 BETAt

+ 5GROWTHt+ t

(3)

Variable

Coefficient

T-statistic

Constant

4.106

6.480

ROAt

0.058

23.471

MKTBVt

0.012

3.390

SIZEt

0.245

24.367

BETAt

-0.086

2.663

GROWTHt

0.024

3.665

Adjusted R2: 39.82%

F=107.732

Note: Statistically significant annual dummy variables are estimated (not

reported) over pooled cross-section samples of firm data.
Definition of Regression Variables:
SCOREt

= Firm Reputation Score in year t taken from Fortune Magazine

Annual Reputation Survey.
ROAt
= (Income Before Extraordinary Items Deflated by Total Assets) *100
in
year t.
MKTBVt = Market Value of Common Equity Deflated By Book Value of
Common Equity in year t.
SIZEt
= the natural log of the Market Value of Common Equity in year t
BETAt
= Market Model Beta computed as 5-year (60-month) time period,
ending at the end of year t (as computed by Compustat).
GROWTHt = (Sales t-5 Salest)/ Salest .

19

Table 3
Descriptive Statistics for Variables Used in Market Value Model
Variable

Mean

Median

Std. Deviation

MVt

6702.344

2974.555

10983.647

BVt

3261.155

1623.376

4978.992

INCOMEt

458.549

206.443

894.561

SCOREt-1

6.445

6.480

0.881

NonFREPt-1

0.000

0.041

0.684

FREPt-1

6.446

6.470

0.561

N= 2,881 Firm-year Observations

Definition of Variables:
MVt
=
Market Value of Common Equity at year t.
BVt
=
Book Value of Common Equity at year t.
NIt
=
Net Income Before Extraordinary Items at year t.
NonFREPt-1 =
Nonfinancial Component of Firm Reputation derived by
taking the residual value from the estimation of firm
reputation in equation 3.
FREPt-1
=
Financial Component of Firm Reputation derived by
taking the residual value from the estimation of firm
reputation in equation 3.
=
Firm Reputation Score in year t taken from Fortune
SCOREt-1
Magazine Annual Reputation Survey.

20

Table 4
Market Valuation of Nonfinancial Components of Firm Reputation

MVt = b0 +

96

DMYy + b1 BVt + b2 NI t + b3 NonFREPt 1 + t

y = 82

(5)
Equation 5
Coefficient
(t-statistic)
1261.419
(3.67)

Coefficient
(t-statistic)
-11566.977
(-13.87)

Coefficient
(t-statistic)
1283.959
(3.68)

Coefficient
(t-statistic)
-24687.711
(-18.39)

BVt

1.068
(32.49)

1.048
(33.29)

1.073
(32.30)

1.030
(32.97)

NIt

4.961
(26.927)

4.398
(24.53)

4.924
(26.49)

3.898
(21.45)

1023.691
(6.41)

1081.10
(7.22)

Constant

NonFREPt-1
FREPt-1

4170.684
(19.95)

SCOREt-1
Adj. R2

2062.755
(16.74)
71.77%

74.20%

72.02%

75.41%

Definition of Regression Variables:

MVt
=
Market Value of Common Equity at year t.
BVt
=
Book Value of Common Equity at year t.
NIt
=
Net Income Before Extraordinary Items at year t.
NonFREPt-1 =
Nonfinancial Component of Firm Reputation derived by
taking the residual value from the estimation of firm
reputation in equation 3.
FREPt-1
=
Financial Component of Firm Reputation derived by
taking the residual value from the estimation of firm
reputation in equation 3.
SCOREt-1
=
Firm Reputation Score in year t taken from Fortune
Magazine Annual Reputation Survey.
Variables for which no coefficient was reported were not considered in that
version of equation 5.
21

ENDNOTES
1

We also ranked the residuals and used the ranking rather than the residual, with no qualitative
effect upon the results.
2
It is possible that firm reputation varies by industry. As a test of robustness, we include industry
dummy variables in the estimation of models 3 and 5 and find 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 financial
(FREPt-1) and non-financial components of reputation (NonFREPt-1) beyond the lagged market
value of common equity, MVt-1 and find NonFREPt-1 to still be positive and significant.

22