In the financial markets, the ultimate barometer of a company’s performance is without doubt its market value –and that’s just based on the price investors are prepared to pay for its shares. But what makes a buyer bid up the price of a company’s shares? Research shows that, in most such things, the best predictor of the future is generally the past. So nothing drives up market value faster than a company’s returns: The higher its past profitability, the more likely investors are to feel confident that profits will continue to pour in –and so the more value they see in the company.
So why then do some companies who post little or nothing to the bottom-line so often sometimes see their prices bid up to astronomical levels? We see this regularly with unprofitable but ‘promising’ IPOs like those of Facebook and Twitter. We’ve also seen it consistently with online retailer Amazon. As figure 1 shows, growth in the company’s market value has far outpaced the S&P500 and virtually all others in the past decade.
Figure 1: Amazon’s Skyrocketing Market Performance (2006-2016)
But what of Amazon’s profitability? The chart in figure 2 shows the company’s dismal record of returns pretty clearly, with earnings that have remained flat year after year for as long as most of us can remember. What then has made so many investors want to invest behind the company’s shares?
Figure 2: Amazon’s Revenues & Profits (2004-2014)
That’s because people clearly look at more than past profits when they judge a company. According to capital market theory, investors assess companies based on expectations about their future prospects: The better we judge a company’s prospects to be, the higher the price we’re prepared to pay for its shares–and so the higher the company’s market value.
The key question to ask, then, is what drives investor expectations? What makes people get enthusiastic about buying up one company’s shares, while running for the hills at mere mention of another?
The simple answer is sentiment –what people think and feel. This is where psychology meets economics. It turns out that investors are just like the rest of us in judging a company based, not only on hard data like profitability and risk, but on everything they read and hear about the company. Savvy investors might well read the reports and recommendations of professional analysts. Others may keep up with feature articles in the media. Less sophisticated observers might be just as heavily influenced by social media and TV ads –and they all might connect through random chatter online or at a bar. What Reputation Institute and others have shown from empirical research conducted as far back as 1990 is that sentiments arise as much from deep knowledge as they do from personal experiences, hearsay, and virtual encounters. That’s why when trying to understand a company’s market performance, it’s so important to understand a broad range of influences on stakeholder sentiment.
To examine this, we recently studied the market movements of top-rated companies in 2016. Specifically, we built a statistical model to predict a company’s market performance based on five main influencers:
- Operating performance
- Social performance
- Media Exposure
- Analyst Recommendations
- Public Attractiveness
The results were interesting. In particular, we found these five predictors to work well as a system in explaining the market values of the sample of 270 companies we analyzed. Each predictor influences the other. And each one contributes to creating either a positive or a negative performance spiral.
Take Amazon. If we unpack the company’s performance, we see that, despite weak profits, in 2016 it was rated favorably by the general public (it was actually #1 in Reputation Institute’s public ranking in March 2016). It was also among the most recommended by analysts in the 1st quarter. In fact, the optimistic views of these two stakeholder groups have fueled an upward performance spiral for Amazon that has largely laid waste to any negative media coverage about the company’s brutal workplace culture or to occasional questions raised about its lackluster social performance. Instead, favorable sentiment has buoyed investor enthusiasm and sent the stock soaring over the past decade. That’s a positive performance spiral in vivo. Positive public sentiment suppresses negative media and fuels rising market values that have made available to the company large amounts of low cost growth capital, which its leaders have used strategically to grow revenues and signal the promise of future profits.
In contrast, companies also regularly fall victim to downward performance spirals. Most of these are precipitated by unexpected events that are widely and negatively covered in the media. The negative coverage lowers public sentiment, raises costs, and leads to reduced forecasts of future profitability that, in turn, precipitate a decline in the company’s market value.
That’s what happened to Samsung Group, Korea’s troubled maker of those exploding Galaxy Notes 7. In March 2016, Reputation Institute had named Samsung 3rd on its list of the most reputable companies in the U.S., behind only Amazon and Hallmark. The rating reflected the high level of trust the company had earned with buyers of its products. Following the release of the company’s well-received Galaxy S7 line of smartphones, the company’s shares were bid up by investors to an all-time high. That’s when a seemingly minor design flaw in the company’s Notes 7 was reported to have led some to spontaneously burst into flames. As more of them did so, Samsung announced one of the industry’s largest recalls in September 2016. It didn’t work. Within weeks, the company would opt to kill the Galaxy Note 7 line entirely, and told investors to expect the crisis to cost the company some $3 billion in lost future profits.
Clearly what began as a product problem turned into a hard-core reputation crisis. Based on a daily poll it conducts of some 4,800 consumers, market researcher YouGov reports that Samsung’s ‘buzz’ score fell steadily between June and October 2016. Clearly it is one component driving Samsung into a downward performance spiral, one characterized by negative media coverage, a costly recall, regulatory intervention, lowered consumer sentiment, resulting in downward pressure on revenues, profits, and analyst ratings.
No one can doubt that this downward spiral will lower Samsung’s market value significantly in the coming weeks from the lofty highs it had risen to in the third quarter of 2016. Figure 3 shows how Samsung’s market performance actually began outpacing arch-rival Apple in the 1st quarter of 2016 and dominated Apple in the 3rd quarter. That trend helps explain why Apple had not earned top ratings from the public in Reputation Institute’s Q1 2016 survey. It also shows that Samsung is already losing ground as a resurgent Apple takes advantage of changing stakeholder sentiments now favoring its iOS platform over Samsung’s Androids.
Figure 3: Samsung against Apple (Oct 2015-Oct 2016)
My point is this: Performance is a balancing act. To do well in the market place, a company has to please most of its stakeholders all of the time. But that’s no easy task. That’s what makes the quality of a company’s leadership so important –visionary leaders like Amazon’s Jeff Bezos help to demonstrate a company’s excellence by successfully balancing the often conflicting demands made of them by investors, customers, employees, suppliers, and regulators. It involves stabilizing the forces that can push a company into an Amazon-like upward spiral, against the crises that so often precipitate a Samsung-like downward spiral.
Note that it’s during a downward spiral that a company often benefits most from having a strong record of social performance and good public perceptions: Favorable non-financial ratings of the company can offset the downward pressure on its market performance from a decline in operating performance. Amazon’s centralized structure, visionary leadership, and activist agenda are fueling growth. Samsung’s diversified structure, lack of visible leadership, and somewhat generic social platform are not helping the company dampen its current downturn.
 Fombrun, C. “How do you Rank the World’s Best CEO’s?” Harvard Business Review, February 6, 2015.
by Dr. Charles Fombrun (@reputationguru)
Founder & Chairman, Reputation Institute