Driving Enterprise Value Growth through Reputation Management

As economic growth slows, Chief Financial Officers (CFOs) are focusing on cash flow, net profit, and how long companies can withstand a shutdown. However, what they should really focus on is the emotional factor of "fear."

Consumer spending contracted faster in the first quarter than most analysts expected. Clearly, households had already adopted social distancing measures on their own before official "stay-at-home orders" were issued.

As a result, forecasting models based on consumer spending have deviated, and such deviations will persist if financial models fail to incorporate behavioral factors like fear as drivers of the economy. In the next round of earnings calls, CFOs might lead a discussion on behavioral economics and information economics.

Over the next quarter, managing fear, anger, and disappointment will become the "X factor" influencing corporate equity and debt pricing. This factor has a name: reputation risk management.

Reputation Resilience

Every industry will see winners and losers. What evidence do corporate executives have that their companies will weather the storm relatively steadily compared to peers? What signals can they send to convince the market of their ability to protect brand value and equity and drive a cash flow rebound?

Decades of analysis of corporate reputation resilience have enabled the construction of parametric models demonstrating the close correlation between reputation and stock prices, bond ratings, and cash flow. This is because reputation stems from stakeholders' expectations of corporate governance and operations, and companies that meet these expectations reap tangible rewards.

A study by my company, Steel City Re, of reputation crises over the past decade found that three factors predict 60% of the variance in the depth of overall equity value loss and the extent of recovery: pre-crisis reputation risk management, balance sheet strength, and the scale of stock buybacks.

In the COVID-19-induced economic contraction, we similarly observe early substantive effects of pre-crisis reputation risk management—accounting for about 10% of the variance among peers—reflected in balance sheet strength.

BNY Mellon is a typical case. Under the leadership of new CEO Todd Gibbons (a former CFO), BNY Mellon disclosed in its recent 10-K filing and proxy statement multiple upgrades to its reputation risk management mechanisms, and the stock market responded positively. During the COVID-19 market crash, BNY Mellon successfully preserved its equity value.

More importantly, compared to a peer group of 12 companies, by market capitalization, it rose from fifth to third place between June 6, 2019, and May 7, 2020, with the relative improvement occurring entirely in 2020. That is, through publicly disclosed enhanced reputation risk management measures, the company achieved relatively more resilient market capitalization performance.

Such cases are particularly instructive at this time. When there is a strong evidence-based correlation between stakeholders' expectations and actual performance, reputation value and reputation resilience emerge. In short, companies with strong reputation value and risk management processes are more likely to outperform industry peers in stock price during crises.

Recognition of reputation value and its risk management among institutional investors and bond rating agencies is rising. Just this year:

• Institutional investors report that in asset allocation decisions, reputation risk and its management rank second only to environmental, social, and governance (ESG) issues in importance.
• Moody's reports that reputation and its risk management played a substantive role in 30% of its recent ratings.

Although recognition of reputation value is rising—according to a survey of CEOs this year, reputation accounts for an average of 76% of the market value of high-performing companies—other signaling tools have been weakened. The most effective tool—stock buybacks—is no longer available to any company receiving federal bailout funds, which in itself is a signal: at least in the eyes of lawmakers and regulators, stock buybacks will be viewed negatively, even for companies that decline federal funds.

Meanwhile, the story told by ESG metrics is being undermined by a lack of consistency and credibility. As one financial advisor told the Financial Times: "I don't believe in (ESG) indices. They use self-reported data, and I don't buy it at all." A U.S. Securities and Exchange Commission (SEC) commissioner has also publicly dismissed ESG trends, describing them as "labeling, public shaming, and avoidance based on incomplete information, wrapped in moral preaching, with a cold, self-righteous disregard for consequences that ultimately fall on real people."

Even corporate marketing narratives must undergo stricter scrutiny, aligning them with objective, provable facts about company operations and performance. Plaintiff lawyers in shareholder lawsuits have successfully challenged the defense that marketing claims are merely "corporate puffery," with courts ruling that such claims can indeed serve as a basis for claims.

All this points to a clear path forward. CFOs need to work with general counsels and risk managers to mobilize departments across the company around the goal of identifying and mitigating reputation risk.

Only after taking these steps—and examining and addressing governance and operational issues from a reputation risk perspective—can the marketing department join the team to convey a story that boosts stock prices and influences the cost of capital in difficult times.

Reputation resilience, achieved through data-driven analysis and improvement and validated by external underwriting, will protect cash flow and the cost of capital. This is the signal that companies will not only survive but also lead their industries. It is a story that investors, analysts, bond rating agencies, regulators, and legislators can all understand.