Integration of ESG in Valuation – A Summary

Written by: Labanya Prakash Jena, CFA

“The business of business is business.” This statement of Milton Friedman influenced corporates for many decades to focus only on profit generation and shareholders’ value creation, while social and environmental failure is left to the Government to rectify. Business has evolved significantly over time, and business decision-makers are now increasingly hearing the stakeholders’ voices. The stakeholders’ voices can be mapped through Environment, Social, and Governance (ESG) matrix. There is ample empirical evidence on how ESG factors positively affected corporates’ operating and financial performance. ESG, as a factor in investment decision making, was ethics-based a decade back but is currently considered a material risk (opportunity too).

Easier said than done! The real question from a practitioner is how to integrate ESG into investment decision-making. The corporates in developed countries, particularly in Europe, have started disclosing useful information for investment decision-making due to constant persuasion from Governments, regulators, and civil society. On the contrary, corporates in developing countries, including India, have lagged. Moreover, ESG as a subject has not become mainstream in the business and finance curriculum in universities and business schools yet. The investment industry experience in integrating ESG in investment practices is also at a nascent and evolving rapidly. The lack of disclosure by corporations, limited exposure to ESG in education, and limited industry experience make it hard for investment analysts to integrate ESG into investment practices. In this article, I have attempted to show a path that can help analysts integrate ESG into investment decision making. These aspects are outlined in the steps below.

Step 1: Identify Material Issues

The first step is to identify the ESG issues, information, and data points material to the company considered for investment. The ESG issues are heterogeneous and vary considerably across sectors, industries, and companies. Hence, viewing all the ESG issues may not be necessary. The analyst should focus on those ESG issues that are highly likely to be realized. The magnitude of the impact of those issues on the company’s financial performance under consideration should also be very high enough to be considered material. For example, GHG emission is not material for the financial services industry since it is not energy-intensive but vital for the iron and steel industry or energy production companies. In this context, Sustainable Accounting Standard Board (SASB) has developed a useful framework (named as SASB’s Materiality Map) that identifies ESG issues that are likely (or not likely) to affect the operating and financial performance of the companies in an industry.

However, it is noteworthy that the analysts should conduct their analysis to determine the issues and form their opinions on the material risks; the SASB framework only offers guidance in this regard. The analysts should not consider ESG issues only as a risk but an opportunity for the company to grow and prosper. For example, a rapidly transitioning energy company from fossil-fuel (coal, oil, and natural gas) based businesses to clean energy (solar or wind) is an opportunity. Similarly, for a beverage company, product safety and consumer welfare are essential. Taking extra care of these two issues would help the company grow faster and/or add a premium on its products than the industry.

Step 2: Collecting and Collating Information/Data Points

Publicly listed companies are bound by regulation to disclose information (called risk factors), which are material. Whenever the corporates disclose issues concerning ESG voluntarily or by securities regulation, the quantity, and quality of corporate disclosure are not very useful for making an informed decision. Unfortunately, ESG risks are not adequately embedded in securities (stock or bonds) regulation in the capital market, both in developed and developing markets. Fortunately, some corporates, particularly those following the Global Reporting Initiative (GRI) principles in their reporting practices, voluntarily disclose useful information or data points related to ESG issues. Nonetheless, the company’s financial and sustainability report (if available) should be the primary source of material information/data points associated with ESG issues.

Several third parties such as MSCI, Bloomberg, CDP, Refinitiv, and Morningstar are currently offering research services to investors concerning ESG; these agencies also rate companies based on ESG issues (just like credit rating). These third-party research reports are useful for understanding, analyzing, and establishing a view on the company’s ESG issues. However, the analyst must be careful about ESG rating since the ESG rating of a company also varies among the rating agencies due to significant differences in the agencies’ scoring methodologies.

Besides company reports and ESG research services, the analyst can collect and collate information about ESG issues from other sources such as newspapers, research reports, technical journals, and even social media and networks. Newspapers report various information related to a company’s operation, for example, business disruption to a company’s operation due to a labor strike, industrial disaster, or protests by the local community. The research reports offer various insights and market intelligence on industries (for example, forecasting in carbon pricing and possible regulatory changes in a particular sector). Technical journals provide empirical evidence on specific issues on ESG or technological changes (for example, an invention of an energy efficiency technology that can replace an inefficient technology) related to ESG issues. Social media and networks give some useful inside information that is not readily available in media. For example, a company’s employees divulge and share information on human resources practices, diversity, and the company’s inclusion in social media.

Step 3: Application of ESG in Valuing Stocks

After collecting and collating issues related to ESG, the analyst can evaluate the impact of these issues on the company’s financial and operating performance and, consequently, its valuation. The analyst should adjust the company’s projected financials appropriately in the financial model. When adjusting the financials, the analyst needs to examine the ESG risk management practices of the company. For example, if a company is paying a lot of attention to control the ESG risks emanating from the industry’s inherent characteristics, the impact of ESG on the company’s operating and financial performance would be moderate. This kind of ESG governance can help the company to outperform the industry in the future.

Financial Projection

At this stage, the analyst assesses ESG issues’ impact on the company’s projected revenue, expenses, CAPEX, book value, and capital cost and adjusts all these elements in the financial model:

– Revenue: ESG can affect the top line, both positively and negatively. For example, the company operates in an industry that is adversely affecting the environment (combustion cars), and there are progressively competitive substitute products (electric cars). In that case, the company’s revenue would likely decline if the company cannot compete in the new (electric car) industry in the future. Similarly, if food and beverage companies face serious food safety and product labeling issues, it may take a long time to win their consumers’ trust. For battery manufacturing company transition to clean energy can be a massive opportunity for growth since energy storage plays an essential role in energy transition (from fossil-fuel-powered to clean (wind/solar) energy). The critical assets of many industries like hotel and retail are the human resources; employee-friendly policies lead to superior customer experience resulting in higher sales.

– Expenses: There are several ways (for example, fragile risk management system to manage ESG risk, stringent regulation on carbon taxes) ESG issues can depress operating profit margin. Consider, for instance, a company working in a highly carbon-emitting sector. In that case, a sudden surge in carbon taxes (a highly likely event) will swell its operational expenditure. Likewise, a financial service may incur substantial trading losses if the management has not developed a proper risk management system to reduce cost of rogue trading risk. A company with a better relationship with the labor union and local community can reduce the risk of business disruption due to labor strikes and social unrest, consequently, reduce the cost of operation. High retention employees can reduce the cost of hiring and training and improvement of productivity of employees. Better corporate governance (for instance, protection of minority shareholders or better financial disclosure) can reduce capital cost over the long term.

– CAPEX: Since the regulators are becoming increasingly stringent (due to pressure from the Government and civil society) on energy efficiency and carbon-intensity of the industrial plants, the corporate must upgrade its plants to meet the increasingly strict regulations on energy efficiency. If the company is not upgrading its plants, any new regulation can force the company to incur significant CAPEX to upgrade the plant to meet regulatory norms. The analyst can adjust the future CAPEX accordingly if the company’s plants are below industry standard or there is a possibility that the whole industry could face regulatory scrutiny in the future. A company with upgraded pants (foreseeing stringent regulation) will not have to incur massive CAPEX suddenly, which startle investors and may lead to a fall in stock price.

– Book Value: If the company’s plants (assets in the book) are sub-standard in energy intensity or carbon-emission, there is a limited scope for upgrading the plans; a stringent regulation will force the company to write-down the value of the plant from its balance sheet. Similarly, if a bank’s home loans are concentrated in localities exposed to the risk of flood and sea-level rise, the home buyers may default on the loans as their value may erode to less than the outstanding loans.

– Cost of capital: The capital providers (both debt and equity) are increasingly concerned about ESG issues since these risks are already considered material risks. Hence, the incorporation of ESG risk in investment decision making will affect the cost of capital. It is possible that a company that is highly exposed to ESG risks might have raised capital in the past at an attractive rate; it may not be possible in the future. Hence, the analyst should accordingly adjust the cost of capital, by 1-2%, for example, (both equity and debt) in the discounted cash flows model. It is noteworthy that the capital cost of ESG risk can also be quantified by using sophisticated statistical and mathematical models. However, the financial models quantifying the capital cost of ESG risk is at an early stage and not so much accepted in investment practices.

– Terminal Value: Terminal value contributes a significant portion to the company’s valuation, particularly for the company expected to grow rapidly for the next many years. If the ESG risks are appropriately adjusted in the projected financials (let us say ten years projected financials), adjustment to terminal value regarding ESG risk is not required. However, if ESG risks are not adjusted correctly in the projected financials, it is challenging for analysts to estimate terminal value through the ESG risk lens. The analyst may increase/decrease terminal value based on its exposure to and control of ESG risk. It is notable here that some companies might not have any terminal value if their entire asset is facing stranded risks in the future. Many coal, oil, and gas companies have started declaring stranded assets – these assets are not profitable due to a substantial increase in physical and transition risks.

Valuation Multiple

Based on assessing the company’s exposure to ESG issues and strategic plan and governance related to managing the issues, the analyst can adjust (Premium or discount) price multiples in valuing a company compared to peer companies. For example, an ESG risk may depress the company’s bottom line by 10% compared to peers (assuming all the other factors are unchanged); the analyst can adjust 10% in market multiple. Similarly, an FMCG company is spending heavily on developing a packaging waste collection system while its peers are not doing anything significant, demand a premium on valuation multiple.

Conclusion

The integration of ESG issues in securities valuation is challenging due to the scarcity of data, limited financial disclosures, inconsistent and incomplete datasets, and subjectivity related to identifying and assessing material ESG risk and judgment. Also, there is no consistency in ESG rating among rating agencies, primarily due to differences in their methodologies. With an increasing nudge from the Government, regulators, and civil society, the corporates are increasingly disclosing more and useful information in their financial reports. Moreover, various entities are working together to standardize information that is consistent across time and entities. The Sustainability Accounting Standards Board (SASB), the Climate Disclosure Standards Board (CDSB), the Global Reporting Initiative (GRI), CDP, and the International Integrated Reporting Council (IIRC) are working together to develop frameworks and standards for sustainability disclosure. It should be easier for analysts to integrate ESG issues in valuation with corporates’ better sustainability disclosure as we advance.

About the Author:

Labanya is currently working as a Manager – Climate Finance in Climate Policy Initiative’s (CPI) Delhi office; CPI is an international development and policy consulting company in climate finance. At CPI, he is engaged in research and consulting activities related to policy, regulation, and investment aspects of green financing, including renewable energy. Besides, he is also engaged in designing and analysis of new financial and business ideas at CPI’s Green Finance Lab, aiming to drive capital into the climate sector. Before CPI, he has worked with Copal Amba Research (A Moody’s Subsidiary), Emanation Partners, Skylar Capital, and Mandrill Capital Management in various capacities. Labanya is a management graduate and holds a Master’s in Economics. He is also a CFA charterholder and currently a Doctoral Scholar at XLRI, Jamshedpur.

Disclaimer: “Any views or opinions represented in this blog are personal and belong solely to the author and do not represent views of CFA Society India or those of people, institutions or organizations that the owner may or may not be associated with in professional or personal capacity, unless explicitly stated.”