• Lin Xuanchang, Impact & Outreach Intern
  • January, 2022

The rising importance of ESG factors in corporate analysis and valuation

Environment, Social and Governance factors, or ESG in short, has become unprecedentedly important in corporates’ operational and supply chain management in light of the global pandemic (Unnikrishnan, 2021). Aligning with the growing concern for ESG related issues, corporates worldwide have actively hopped onto the bandwagon and scrambled to brand themselves as pioneers of sustainable practices. In fact, more than 80% of companies worldwide now incorporate ESG disclosure as part of their regular reporting (KPMG, 2020). In the Asia Pacific specifically, the sustainability reporting rate has increased from 78% in 2017 to 84% in 2020 (KPMG, 2020). Undeniably, such a phenomenon is closely pertinent to firms’ rising accountability to ESG management as well as investors’ growing consideration for ESG factors when making an investment decision. According to research conducted by Boston Consulting Group (2021), 85% of investors considered ESG factors in their investments in 2020, 91% of banks monitored ESG risks and 67% of them screened their loan portfolios for ESG risks (Venkataramani, 2021). Failure in adhering to ESG standards and demonstrate sustainable practices by corporates may result in declining appeal to investors, potentially leading to a shortage of capital and shrinking growth potential.

ESG and Corporates’ Fundamentals

One of the reasons why investors nowadays pivot towards ESG investing is because investment into sustainable companies tends to yield more stable financial returns over the medium to long term (Venkataramani, 2021). This is the result of an observed relationship between ESG credentials and corporates’ financial performance (Bendersky, 2019). Analysts have suggested that ESG performance, across a longer time span, could have substantial positive impact on both the revenue and cost performance of a company, as elaborated below

First and foremost, companies with unsustainable practices are prone to heavy fines with added regulatory and remediation costs, as governments nowadays are also engaged in the sustainability race and may hence be less tolerant towards unsustainable firms.

In addition, successfully implementing ESG strategies not only encourages innovation but enhances operational efficiency as well. This is because through the process of tackling pressing ESG issues faced by companies, coming up with technology solutions and innovation are inevitably involved as part of the process given the complexity of ESG problems faced by corporates today. Brainstorming, devising and finally implementing such innovative solutions help strengthen technological capability of a company. This synergizes with the other operational pursuits of a company and contributes to higher productivity and lower operating expense especially in the long run when results of innovation yield. 3M, a multinational manufacturing company, managed to save up to $2.2 billion since 1975 by refining products and equipment, enhancing manufactural processes and recycling waste under it’s “pollution prevention pays program”. This indicates how powerful adherence to ESG could be in cost reduction.

Last but not least, corporates with poor ESG performance may also be more susceptible to external events such as the Covid pandemic and environmental disasters. Not only is there a reduced cost synergy between ESG factors and corporate performance, companies with better ESG performance are also more capable of increased revenue generation. With rising awareness for sustainability issues, up to 70% of consumers are willing to pay 5% more if the products purchased are green, leading to higher revenue for corporates (Henisz, 2019). Furthermore, a robust correlation is also observed between ESG performance and employee morale. (Henisz, 2019). The higher the ESG performance of a company, the higher the employee satisfaction level and productivity, again resulting in better revenue performance and brand reputation. Therefore, a strong ESG proposition can be consequential to a company’s fundamentals, making ESG analysis an integral component for investment research and a pivotal indicator in assessing whether companies will be sustainable and profitable over the medium-long term.

ESG in Corporate Valuation

Given the substantial impact of ESG on corporates’ financials, it has increasingly been factored in as part of the corporate valuation process. Taking the traditional discounted cash flow analysis (DCF) as a primary example, a common way of incorporating ESG into DCF is by adjusting the weighted average cost of capital (WACC). According to UN Principles of Responsible Investing (2016), factors such as human capital, societal resources and natural capital are incorporated as part of WACC calculation, as shown in the graph below. Simply speaking, better ESG performance would lead to lower WACC and hence a lower discount rate when it comes to discounting future cash flow. As such, companies that score well in ESG are likely to be valued higher and are naturally more favorable to investors.

Another way of incorporating ESG in corporate valuation is by adjusting a company’s future cash flow (Bos, 2014). This is especially applicable to significant ESG-related incidents that affect a corporate’s revenue and cost management. For example, the BP oil spill in the Gulf of Mexico in 2010 not only led to high fines but disruption of production and operations as well (Bos, 2014). Upon analysts’ evaluation, events as such may lead to a higher cost projection for BP at least for the next one to two years, leading to a lower valuation and hence poor investor outlook for the company.

However, despite the extensive incorporation of ESG in corporate valuation, there are still some glaring limitations in terms of the credibility of such valuation. First and foremost, sustainability reporting has become increasingly unreliable nowadays. According to a Mckinsey report (2019), investors have indicated that they could not use companies’ sustainability disclosure to inform investment decisions and advice accurately. Solely relying on ESG information disclosed by companies may result in falsifying assumptions and valuation results. In addition, unlike quantitative indicators such as an increase in the number of products sold by manufacturing companies, ESG often includes qualitative indicators that are hard to quantify.

Therefore, given the rising importance of ESG factors in corporate analysis and valuation, it is consequential for regulatory authorities to enforce authenticity and standardization in ESG reporting. This will help investors and the wider public better understand the intrinsic value of a corporate and make appropriate investment and consumption decisions. At the same time, corporates could also better benchmark themselves against industry peers to identify areas of improvement and how they could position themselves at a better premium. Together with the emergence of ESG analytics companies that help investors better understand the ESG performance of companies, we expect to see a healthy competition among firms to scale up their ESG efforts, collectively contributing to the resolution of numerous environmental and social issues in years to come.