Incorporating ESG metrics into business valuation is critical

The translation of ESG factors to cash flow adjustments varies. [iStockphoto]

Environment Social and Governance (ESG) in the investments space has evolved over the past years from “wait and see” approach to ESG becoming an integral part of the way investors analyse how companies create long-term sustainable value and growth.

Currently, investors are adopting different ways to measure the ESG impact on the value of a business, a trend that is likely to continue in the coming years.

While the traditional business valuation approaches are still prevalent, the approaches are based on market and industry forces with a financial lens only.

The ESG factors were considered an afterthought as such overlooking and underestimating value drivers and risks that would help investors gain better insights into the materiality and potential impact of ESG factors on the total valuation.

However, to ensure transparency and avoid the uncertainty surrounding the positive or negative impact of ESG-related issues on the valuations, investors should now consider and quantify the ESG impacts on the cash flows, discount rates, or multiples of the subject company using data, assumptions, and scenarios.

While discount rate adjustments can be used to incorporate ESG into the Discounted Cashflow approach (DCF), adjusting the discount rate may lead to double counting if beta values have reflected the market’s perspectives on ESG risks. A better way of integrating ESG factors in the DCF is by adjusting the future cash flows.

This helps the investor to integrate the company’s ESG factors into future cash flows and thus to focus on the relevant material issues. Depending on different industries and company performances, the translation of ESG factors to cash flow adjustments varies.

Industry lens

Hence industry to industry lens is very critical since there is no standardised benchmark in ESG integration and adopting industry and company specific value drivers could help avoid the ambiguity of the cash flow adjustments. Some of the adjustments to be considered include:

The Environmental “E” factor can be incorporated by adjusting the cashflows with additional costs and Capex investments in carbon reduction initiatives and costs savings from adoption of energy/water saving technology.

The Social “S” factor can be incorporated through adjusting costs related to employee training programs, hiring contractual employees on a permanent basis, workplace safety measures and research and development investments to ensure quality and safe products among others.

The Governance “G” factor can be incorporated through adjusting for fines or penalties imposed by regulatory authorities due to weak governance policies of companies.

In terms of the timing of the valuation, the impact of the “G” can be incorporated directly on the “as is basis” valuation by deducting the quantified impact from the enterprise value of a company.

The “E” and “S” impact can be incorporated through the post money valuation as this will be assessing the “E” and “S” impact as a value creation or reduction depending on the applicable industry and country specific ESG frameworks. However, unless there is a defined ESG benchmark, it will be difficult to make the “E” & “S” adjustments on the “as is basis”.

Whilst only measurable ESG factors are included in projected cash flows, known and knowable information which would impact how investors would view an investment and what they would pay for an investment should be included in each fair value determination. Qualitative factors may not be quantifiable though they may impact what an investor would pay for investment.

These considerations may include the impact of green building standards compliance, employing a more diverse workforce, ethics, and transparency. These qualitative factors can be negotiated in the sale and purchase agreements (SPA) to allow the investor to secure their interests in the transaction through contractual protection mechanisms, specific indemnities, and conditions precedent and subsequent clauses based on the known and knowable ESG risks.

While its debatable on how ESG and returns are interlinked, it is important to note that sustainability initiatives at corporations tend to drive financial performance due to factors such as improved risk management, long term cost optimisation and more innovation as opposed to ESG reporting disclosures in isolation.

Different eras have also played a vital role in the evolution of ESG similar to the way generations have changed in values and ideals over time.

It is vital to appreciate that the current ESG frameworks are not a cast in stone, and it will continually evolve as investor preferences and perceptions about the relative costs and benefits of ESG policies evolve.

The ESG framework will also evolve with the awakening of the different stakeholders such customers, suppliers, investors, employees and regulators to integrating ESG in the whole value chain and building a corporate purpose and culture around it.