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In the wake of the Toyota recall, more companies grapple with how to manage something they can't measure.
David M. Katz, CFO Magazine
May 1, 2010
As the Toyota Motor Corp. is learning, none of the perils a company faces is harder to measure than damage to its reputation. Other hazards, from a plant explosion to a terrorist attack to a natural disaster, may threaten a company's very ability to operate, but a sullied corporate image exacts a price that other risks don't: devaluation in the eyes of your customers.
Toyota can, of course, compensate buyers, retool its production methods, and invest in image-rebuilding ad campaigns. But it has no real way to predict when, to what extent, or if its brand can regain its former sparkle — or what it may have lost as a result of its vehicles' infamous acceleration problems.
To be sure, metrics tied to a company's brand have long existed. In accounting terms, such things as patents and trademarks, business processes, and training policies are referred to as intangible assets and generally thought to be key components of a brand. When a company is acquired, the buyer accounts for the cost of its new intangibles on its balance sheet and continues to hold them on its books as they depreciate.
But while such assets are certainly measurable as a corporate expense, they don't add up to a reputation. So companies have tried various workarounds. One common approach is to subtract a company's tangible equity from its market value. "That difference, to a large degree, is your reputation," says Bruce Nolop, the CFO of E-Trade Financial Group.
But Nolop agrees that while that calculation sounds straightforward enough, there may be less to it than meets the eye. "What's scary about reputation is that it doesn't have to be something that's true," he says. Goldman Sachs has expressed that fear: in its 2009 annual report it took the highly unusual step of citing, among various risk factors, its belief that, "We may be adversely affected by…negative publicity." Critical press coverage, "regardless of the factual basis for the assertions being made, often results in some type of investigation by regulators, legislators, and law-enforcement officials, or in lawsuits," the investment bank stated in March.
Read All about It
One way to gauge reputation is simply to ask. The Harris Reputation Quotient (RQ) surveys thousands of American consumers to identify and rank the 60 most visible firms. A Harris spokesperson says that at least 6 companies' boards of directors use the RQ score as one component of senior executive evaluations, and Harris is now working to gauge the correlation between a company's RQ and its stock price.
A newer index purports to measure and compare the reputational swings of 7,000 publicly traded U.S. and foreign corporations. Offered by Steel City Re, a consultancy that targets "headline risk" (the risk stemming from bad publicity), the index is based on four "forward-looking" indicators: shareholder behavior, communications effectiveness, operating costs, and a company's ability to command premium pricing based on its brand.
While Nir Kossovsky, Steel City Re's CEO, refuses to reveal the exact calculations that make up "the special sauce" of his index, he notes that Toyota took a steep dive relative to 87 companies with market caps of $50 billion or more, dropping from the 80th percentile to the single digits despite posting financial results superior to the auto industry as a whole. Most of its large-cap peers saw their reputational scores decline and then improve through 2009, but Toyota's did not.
Did investors smell a crisis brewing? "There was some segment of the population that knew something, because we measure people's behaviors," contends Kossovsky, "and there was [investor] behavior that indicated that there were some people that bet against the current status of Toyota."
Darden Restaurants also believes in gauging public attitudes — in this case, the opinions of its customers, says CFO Brad Richmond. Earlier this year, when a survey aimed at the "financial mind-set" of consumers found that they believed that its Red Lobster chain had raised prices (it hadn't) the company launched a discounted dinner-for-two promotion designed not to increase business per se but to reverse that misperception.
A more serious reputational risk for restaurants than erroneous beliefs about price, however, is food contamination. Darden not only conducts rigorous inspections of many foods at their source of production, it is even willing to let perception trump reality. Two years ago, for example, when a salmonella outbreak was inaccurately attributed to tomatoes, Olive Garden stopped serving them — even though it knew through its own inspections that they were not the cause.
Blame It on ERM?
One reason that companies may be particularly vulnerable to reputational risk is that it is not adequately addressed by enterprise risk management, the discipline that many corporations use to prioritize perils. That is largely because quantifying reputational risk separately from other forms of corporate uncertainty violates the spirit of ERM, which stresses that all corporate exposures be analyzed and managed as a whole.
Some CFOs embrace the holistic approach so enthusiastically that they don't even believe in appointing a chief risk officer or similar senior executive responsible for managing risk. "Acting like risk is somebody else's responsibility is counterproductive, because it's incumbent upon each of the senior managers to be a risk manager," says Eaton Corp. CFO Richard Fearon. He recently criticized a proposal by Sen. Charles Schumer (D–N.Y.) that would require public-company boards to form a special risk committee, saying that "everything we do is about managing risk," and therefore shouldn't be assessed in a piecemeal way.
If ERM fails to address reputational risk, insurance may offer a backstop. Companies have long been able to buy coverage for specific reputation-damaging events such as product recalls, directors' and officers' liability, or what is known as "three-d" insurance, that is, the death, disgrace, or disability of a corporate spokesperson.
But interest in insurance that covers a corporation's good name against a broader array of threats is on the rise. One broker, DeWitt Stern, has begun marketing a policy that would cover U.S. companies for up to $50 million in public-relations and media costs stemming from an event "that does damage to your brand and interrupts your normal business cycle," says LeConte Moore, a managing director at the firm.
Insured or not, a company that suffers a reputational hit can mitigate the damage by taking prompt action. Toyota has been battered in the press as much, and possibly more, for the apparent tardiness and ineffectiveness of its response as for the actual mechanical problem(s).
"That's where so many companies fall down," Fearon says. "They won't admit to the mistake in the first place. And by the time they do, there's been huge damage to their reputations."
But reputations aren't necessarily fragile. Toyota posted a large sales gain in March (admittedly helped by incentives) even as the investigations that may further sully its image continued.
David M. Katz is New York bureau chief at CFO.