In 2020, warranty offering S&P 500 firms paid a total of $20.2 billion to cover their customers’ warranty claims, with the average warranty payments being $246.1 million (according to Calcbench). The potential financial implications of warranty claims cannot be overlooked. For instance, in 2012, Navistar faced the risk of bankruptcy mainly due to the enormous financial burden of its warranty contracts.

In a forthcoming study, my colleagues and I examined whether and how offering warranties and unexpected changes in warranty payments affect firm value. Our findings offer important implications for C-suite executives and are relevant to performance measurement decisions.

Does offering warranties work effectively as a marketing tool? Prior literature offers mixed evidence regarding whether warranty contracts help firms signal better product quality to potential customers. Earlier studies have documented that appliances sold by manufacturers that offer longer versus shorter warranty terms are rated as more reliable by customers. In contrast, in the automobile industry, manufacturers with longer warranties have been shown to receive lower quality ratings.

Consistent with the view that warranty coverage is not a reliable signal of product quality, our analysis shows that offering warranties itself does not ensure a higher firm value. If anything, companies that experience unexpected increases in warranty payments have lower firm value than those that do not offer warranties.

Informative Signals

To understand how potential investors interpret high warranty payments, we ran an experiment with individual investors who indicated that they read companies’ annual reports before making stock investments. Using real financial statement data presented under a fictional company name, we found that high versus low warranty payments (i.e., 6% or 1% of revenues) significantly reduce potential investors’ product quality assessments as well as their stock investment likelihood.

Further, supporting the notion that warranty payments are informative signals about product quality, we found that future discussions of quality issues in 10-K’s and analyst reports are more frequent for firms that report higher warranty payments in the current period.

After validating warranty payments as a proxy for product quality information, we analyzed the stock return performance of all warranty offering firms traded on the U.S. stock exchanges. Our sample covered the fiscal years 2010 to 2016 and included 3,014 observations for 666 unique firms.

After controlling for changes in various relevant factors, including profitability, sales, and financial leverage, we found that when firms experience unexpected increases in warranty payments (modeled based on lagged warranty payments), their stock returns are lower by 2.5 percentage points on average. This corresponds to a 17.2% decline in annual stock returns for the average firm in the sample.

Whereas investors interpret rising warranty payments as a signal of declining product quality (“quality losses”) and adjust their valuations accordingly, they do not react as strongly to decreasing warranty payments (“quality gains”). Our results show no significant relation, on average, between stock returns and unexpected decreases in warranty payments. Investors’ asymmetric reaction to rising versus declining warranty payments is consistent with the notion of loss aversion (i.e., losses loom larger than gains).

Warranty Payments

What could managers possibly do to mitigate or even eliminate the negative firm value implication of higher than expected warranty payments? We examined two relevant signals — advertising and research and development spending — as possible moderating factors. Our results suggest that ramping up advertising, but not R&D, efforts can help.

When firms meaningfully boost their advertising expenditures, investors respond less negatively to unexpected increases in warranty payments. Managerial optimism communicated through more intensive advertising counters the negative information conveyed via higher than expected warranty payments.

Interestingly, increasing R&D spending does not help firms avoid investors’ unfavorable reaction to rising warranty payments. That may be because R&D investments involve a great deal of uncertainty and may also lead to a loss in production focus.

Finally, although firms, on average, do not appear to realize any valuation benefits from unexpected declines in warranty payments, our additional analysis reveals that investors’ reaction to the good news conveyed through lower than expected warranty payments is conditional on the recent changes in the industry’s competitive landscape.

If a firm operates in an industry that has recently become more competitive (measured based on industry concentration), unexpected decreases in warranty payments are rewarded with higher stock returns. Hence, in the face of intensifying competition, managers should strongly communicate quality improvements to investors.

Overinvesting in Quality

What are the performance measurement implications of our findings? Product quality and customer satisfaction play an important role in a company’s long-term success. As implied by investors’ valuation decisions, warranty payments made per customer claims are relevant to assess those dimensions.

Warranty payments are an objective measure, which is not subject to potential biases involved in the survey methodology. Tracking changes in warranty payments and tying executive compensation to pertinent benchmarks can help facilitate product quality improvement efforts within the firm and avoid reputational damage stemming from potential product reliability issues and recalls.

Nevertheless, we advise that firms and managers avoid overinvesting in quality improvement efforts. This is for two reasons. First, higher quality comes at a cost, and managers need to balance the marginal cost and benefit of quality. Second, the stock market does not unconditionally reward lower warranty payments. Investors’ reaction depends on the intensity of competition among industry rivals.

Offering product warranties is a double-edged sword. While customers perceive warranties as an insurance contract, warranties come at a significant cost. Investors do not seem to perceive warranties in general as a value-enhancing factor. Rising warranty payments are an indication of potential product quality issues, constituting a red flag for stock market participants.

Ahmet C. Kurt is an assistant professor of accounting at Bentley University.