Can a good reputation encourage risk taking from businesses?

A good reputation is something that most businesses strive to obtain, and so one would imagine such a reputation has only benefits to the organization.  Alas, a recent study from the University of Georgia suggests that there are flipsides to a strong reputation that aren’t so positive.

Whilst the upside brings benefits such as the ability to attract better talent or charge higher prices, it also comes with extremely high expectations that can be incredibly difficult to meet.

“As much as people like to say that the stock market is blind to prejudicial behavior, because it’s run by humans there are a lot of human biases baked into it—and we exposed one,” the authors say. “Reputation is inherently a psychological construct. So, if you do a lot of good over a period of time, people start to expect more from you. If you keep delivering the same old thing, even if it’s a great product, the market may not reward you for it.”

Unrealistic expectations

The research examined how our expectations of firms changed depending on their reputation.  The vanguard in terms of reputation were gleaned from Fortune’s Most Admired Companies list, with these exemplars compared with others in terms of their M&A activity.

The analysis revealed that companies with high reputations tended to make roughly double the number of acquisitions.  What’s more, these purchases are also less likely to be related to their core expertise.  This tends to result in the stock market punishing those decisions with lower stock prices.

“We looked at about 1,400 firms over nearly 20 years and found that high-reputation firms take bigger risks in order to meet or exceed the expectations that investors put on them,” the team say. “Think of a company like Google. We’ve seen it grow up in our lifetimes and start acquiring other firms like YouTube. At first, organic growth is good enough for investors. But, eventually, to satisfy the ever-upward growth that the market demands, they have to start buying other companies because they can’t meet expectations organically anymore.”

Suffice to say, buying other firms is incredibly risky, and history is littered with examples of such acquisitions destroying shareholder value.  This is especially so when the acquisition is not within the company’s core field of expertise.  It’s a double-edged sword whereby the market drives companies towards acquisitions, but then often ends up punishing them for doing so.

“When Microsoft bought Skype, the market reacted by asking, ‘What are you doing?’ But the reality is that Microsoft probably had a lot of good reasons for doing it,” the authors say. “It’s easy to pick on these companies, but we have to assume that firms that have been around a long time with billion-dollar market caps are not inherently dumb.”

Of course, whether this ‘punishment’ in the markets is enough to outweigh the numerous benefits that are derived from an exceptional reputation is something the authors don’t touch upon, but it does provide an interesting insight that managers should be aware of.