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The influence of ESG Criteria on Corporate Valuation


 

Introduction


Environmental, social, and governance criteria. One of the most recently talked-about topics and thought by many to be the “Future of Investing and Financial Planning”. The practice of ESG started in the 1960s as social investing, with some investors excluding stocks or entire industries from their portfolios based on business activities that were considered hazardous for the environment or society in general. This topic was further supported when in 2004 the former UN Secretary-General Kofi Annan wrote to over 50 CEOs of major financial institutions, intending to find ways to integrate ESG into capital markets.


One year later, this initiative produced a report entitled “Who Cares Wins”. The report was produced around the idea that including environmental, social and governance factors in global capital markets makes good business sense and leads to more sustainable markets and better outcomes for societies. At the same time, Bloomberg was introducing “ESG Solutions”, giving investors access to transparent, consistent, comparable data on currently more than 2000 ESG fields and scores for over 11,800 global companies. Institutional investors were initially reluctant to incorporate ESG criteria into their investment decisions, defending that their main duty was to maximize shareholders’ value, but as soon as evidence was released showing that ESG issues have strong financial implications, their course has changed.


Figure 1: ESG & Market Performance









Good ESG performance has continuously been shown to be associated with good financial results. ESG investing has been accelerating since the first studies were published showing the same result: “Stocks of sustainable companies tend to significantly outperform their less sustainable counterparts”. Nowadays, ESG values, along with financial materiality, increasingly became common motivations to many investors, who are looking forward to the incorporation of ESG criteria into the investment process alongside traditional financial analysis. ESG assets are on track to exceed $53 trillion by 2025, driven by investor demand, government regulation, and societal pressure.

 

Effects Of ESG


ESG scores are built through a mixture of many components. Taking Refinitiv as an example, and explaining very broadly, their scoring process “captures and calculates over 500 company-level ESG measures, grouped into 10 categories that are rolled up into three-pillar scores – environmental, social, and corporate governance. The ESG pillar score is a relative sum of each category weights, which vary per industry”.


Figure 2: ESG Scores and Measures

There is a growing consensus that ESG factors have a significant impact on companies’ market values. Researchers state that companies with a good ESG score are usually rewarded by financial markets, while a company with a lower ESG score may indicate that it has a higher risk, due to the less efficient management reported by scoring agencies. As ESG scores are provided by very trusted sources, these give investors a secondary opinion of the company besides traditional financial planning and valuation.


Impact in Discounted Cash Flows


Discount Rate Adjustment

Nowadays corporate valuation is also taking into consideration ESG scores, impacting for example the discount rate: Companies with a lower rating will have on average higher risk profile, so it could be argued that financial analysts should use a higher discount rate (lower valuation) in the Discounted Cash Flows methodology. The reverse holds for companies that score well in terms of ESG metrics. However, this adjustment method raises two challenges:


1) The first concern resides in the measurement of the adjustment’s magnitude. How much should the discount rate be adjusted? Since research in this field is still very limited when compared to others, the adjustment remains a personal decision.


2) The second problem is the double-counting risk. If a corporation has a higher risk as a result of poor ESG factors, and this risk is already known in the market (through a higher beta, assuming CAPM holds), it could be argued that the company’s risk is already reflected in its discount rate, and the latter lacks need of adjustment. Therefore, by adjusting the discount rate again for ESG scores, financial analysts are double counting.


Free Cash Flow Adjustment


Another and better way of integrating ESG factors in DCF modeling is by adjusting the company’s forecasted cash flows. ESG impacts (for example non-compliance with environmental standards that leads to fines, or readjusting the supply chain to create a more positive impact) affect future cash flows and should be integrated into the analysts’ forecasts.


One advantage of this method is that it leads to the translation of ESG factors into future cash flows, creating a more detailed analysis and focusing on relevant material issues. On the other hand, it is very difficult to estimate the impact of events, that depend also on the probability of occurrence. What’s more, trying to assign a value to factors that do not have a specific market (governance factors for example) is problematic.

However, adjusting Free Cash Flows provides a much more accurate valuation, since the assumptions used are clearer than those made in the discount rate adjustment. Sensitivity analyses could be conducted, to take into account different scenarios and gain better insights into the impact of ESG factors on the overall valuation.



Impact In Trading Multiples


Adding to the DCF valuation, one very popular valuation is multiple analysis. To add an ESG impact into multiples, such as Price/Earnings or EV/EBITDA, we can simply adjust them. By adding a premium to the target multiple for companies that have a satisfying ESG Score and applying a discount for those which scored poorly, we can adjust multiples for ESG factors. This method raises the same flags as Discount Rate adjustment. Despite this, these two methods make the effort to consider ESG factors into the valuation of a company, so they are not completely absent from an investment decision.

 

Future Impacts


The future of ESG integration into the corporate valuation is very clear for the near future. As there has been a growing momentum in favor of this activity in recent years, this trend is likely to continue in the following years. ESG Factors can be integrated into a company’s valuation in several different ways, and more differing methods are coming as the field has still a large amount of space to grow. Many other concerns have been raised, such as Green Washing and the Bubble Effect that has been talked about, as possible barriers for an effective valuation. Therefore, integration into the valuation is still a consideration that needs improvement.


Written By: Pedro Calixto


ESG Investing - BSBB Article
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