The impact of ESG on valuation

We hardly need to point out that ESG has evolved considerably. Once upon a time, only a small number of investors used the term ‘sustainability’, but the issue has now become a priority among companies that place it at the heart of their strategy, as well as among investors and the entire stakeholder community. A strong ESG proposition generates long-term value in top-line growth, increased productivity, and investment and asset optimisations, and indicates that the company is opting for every aspect of sustainable growth: in people, resources, the supply chain, customers, and the products or services that the company delivers.

Many surveys focus on stakeholder opinions; studying value creation in relation to the impact of ESG is still a fairly recent development. “ESG is not easy to quantify,” Peter Van Assche, Director of Valuation & Business Modelling at Deloitte Belgium, tells us. “However, a CFO needs to know whether to make additional investments to further improve the company’s ESG rating.”

Multiple and DCF valuation method

“In terms of multiple valuation, a positive impact was demonstrated across different sectors in the Deloitte study that compared the ESG rating to the valuation by trading multiples (EV/EBITDA). Companies with a higher ESG rating turned out to be valued by the market at a higher multiple of the premium.”

Deloitte Belgium started carrying out its own analyses using the DCF valuation method, a more complex exercise for which you need several significant inputs. These include the WACC, determined by the CAPM model (cost of equity/cost of debt), and the five-year beta as a major driver.“The aim was to measure a quantifiable impact of ESG rates on the cost of equity/debt. Additionally, we wanted to know which component, E, S or G, weighed most heavily in the valuation.”

So what did the results show? As with the multiple valuation method, the DCF calculations showed that ESG had a significant, positive impact on valuation. “Of the three components, E and S have a direct influence on financial metrics. Governance is more difficult to quantify in order to see measurable effects. Clearly, though, strong governance cannot be ignored in the general value-based framework.”

Effect on the WACC

A higher ESG rating leads to a lower beta, reducing the cost of equity where all else is equal. At the same time, a higher ESG rating leads to a decrease in the cost of debt/financing. Both elements result in a lower WACC, which leads to a higher valuation. The different components, E, S and G, do not have the same impact, but there is a clear logic behind this. It should come as no surprise that E and S are the most pronounced components. G is more difficult to quantify at present. You can establish the E-component through various objective, quantitative parameters: CO2 emissions, water use, energy, and so on.

The S-component can be quantified for certain parameters and described qualitatively for others. Thus, the impact of E and S can be demonstrated more clearly. We established this for ourselves in our own analysis as well. What impact does an improvement in an ESG score have on a valuation? Value creation in ESG results in a reduction in the WACC. As such, it has a positive effect on the valuation of the company, without taking into account the cost of the ESG improvement.” In a hypothetical exercise based on a fictitious business plan, Van Assche calculated that a 10-point increase in the ESG rating had a positive impact of 5 percent on the enterprise value of a company.

Would you like to consult the study ‘How ESG implementation impacts key valuation metrics’ in detail? Scan the link below.

From strategic discussions to acquisitions

It is clear that ESG affects several fundamentals of the finance department’s work. That is why Deloitte focuses specifically on the role of the CFO when it comes to sustainability. Eline Brugman, Sustainability Partner & Climate Lead at Deloitte, tells us more:

“CFOs have experience with compliance from their background in finance. Now non-financial compliance is being added to that and needs to be integrated into the company’s reporting. However, compliance should not be the driver. After all, ESG has an impact on the business model and value creation. We incorporate all of these components together into our services. So what do we think is definitely needed? A strategic discussion of how highly the company scores in terms of ESG and about the effect that currently has on financing and valuation. Finance has various roles to fulfil. There’s the strategic role that involves including ESG in strategic talks about issues such as allocation of capital, generating financing, and investment decisions. Integrated performance management helps to guide the company’s strategic choices. Finance has a pioneering role to play in integrating risk thinking into the organisation. What are the possible consequences of an action and how do we deal with them? Valuation is also significant if you want your company to be taken over, or if you are considering expansion. This is also relevant from an investment perspective, because you need to know what type of companies you want to invest in, or which companies you intend to acquire. Companies that score poorly on ESG may have great potential for improvement. Conversely, you might immediately start competing in the highest ESG segment to strengthen your portfolio of companies. Tackling sustainability is a trend that we are seeing from PE companies or investment companies. How can sustainability contribute to the sustainable growth of the individual portfolio companies on the one hand, and the investor’s portfolio of companies on the other?”

Aligning the ESG rating

“Specifically for ESG due diligence, we conduct an analysis of the company’s attitude to ESG,” Van Assche continues. “By degrees, we are seeing an increasing focus on ESG for valuation. If you only consider private equity players, you will see that the focus on ESG has become enormous.

That makes sense, because the amount invested in ESG is increasing every year, partly on the assumption that it is associated with a potential increase in value. So ESG is clearly doing what it is supposed to do: that is another conclusion we can draw from the study. Targeted investments in ESG implementation increase business value, but the communication between rating agencies needs to improve in order to align companies’ ESG scores better.”