An Empirical Analysis of the Value of Corporate Reputation in Explaining Variations in Price Earnings Ratios (1999)

INTRODUCTION The price ratio has long been used as an investment analyst's tool to assess growth potential and investment risks. Studies by Beaver and Morse (1978) and Zarowin (1990) confirm the long-held belief that variations in the price ratio values are primarily influenced by expected growth potential and perceived investment risk. However, both studies conclude that these factors do not explain all of the variation and suggest that further research be conducted to identify other important factors. One such factor hypothesized by the aforementioned research is the effect of accounting method choice on variations in price ratios. If two companies with equal economic circumstances choose different accounting methods to account for similar transactions, the price ratios for the two companies will vary simply because their per share differ. Given equal economic circumstances, the stock prices should be nearly the same. A study by Little (1998) concluded that a of earnings variable used as a surrogate measure for the effects of accounting method choices was significant in explaining some of the additional variance in price ratios. Along with projected EPS growth and investment risk. However, the stud suggested that significant unexplained variance remains and that other factors should be explored. In this study, we hypothesize that another important factor may be a corporation's reputation. Reputation can be viewed as capturing a combination of a firm's social and economic contributions. Previous research suggests that positive reputations allow firms to mitigate drops in stock prices in bear markets, charge premium prices, attract better applicants for its work force, attract investors, lower costs of capital, and enhance competitive status. (See, for example Beatty and Ritter, 1986; Caminiti, 1992; Milgram and Roberts, 1986; Fombrun and Stanley, 1990; Vergin and Qoronpleh, 1998; and Little, Jones, and Jones, 1999). If these assertions are true, then a measure of corporate reputation should contribute to explanation of variance in price ratios beyond traditional measures of risk, growth potential, and quality of earnings. This research tests the significance of Fortune's reputation ratings in explaining variance in price ratios in addition to the variables capturing expected growth, investment risk, and quality of earnings. BACKGROUND STUDIES Background studies by Beaver and Morse (1978) and Zarowin (1990) conclude that indeed there are variables other than growth potential and investment risk that explain differences in price ratios. Beaver and Morse (1978), for example, found that growth potential and risks on average explain approximately 50 percent of the variation in price earning ratios. Accordingly, they concluded that other factors important in explaining price variation, such as the effects of accounting method choices. Little (1998) examined the accounting method choice hypothesis for companies in the oil and gas industry. A variable named of earnings (cash flow operations divided by net income) was used to capture the accounting method choice phenomenon. The study concluded that of earnings did significantly explain an incremental portion of the unexplained variance in price ratios after considering the effects of the traditional variables, protected EPS growth, and investment risk. However, a significant portion of variance in price ratio remained unexplained, suggesting that other variables might be explored. A number of studies have suggested that a company's reputation has a significant impact on stock prices. For example, Little, Jones, and Jones (1999) examined the relationship of a company's fortune magazine reputation rating to the size of stock price drops in stock market crashes of varying security. …