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Consideration of ESG in Business Valuation
Let us begin by understanding what ESG stands for! ESG represents Environmental, Social and Governance. ESG investing and analysis has become of increasing interest to investment professionals, in particular the institutional investors globally as governments, large asset portfolio owners, and high-net worth investors have begun to consider the impact of ESG factors on their investments and the respective local markets.
According to a recent study by Morningstar – How Does European Sustainable Funds’ Performance Measure Up, over the 10-years through 2019, nearly 59% of surviving sustainable funds across the categories considered have beaten their average traditional counterpart. More sustainable funds have survived in the past 10 years, in relative terms. Of sustainable funds available to investors 10 years ago, 72% have survived, compared with less than half (45.9%) of traditional funds. Sustainable funds held up better than their traditional counterparts during the COVID-19 sell-off, delivering superior returns in all but one category.
There is no one exhaustive list of ESG examples. ESG factors are often interlinked, and it can be challenging to classify an ESG issue as only an environmental, social, or governance issue, as the table below shows. These ESG factors can often be measured (for example, what is the employee turnover for a company), but it can be difficult to assign them a monetary value (i.e., what is the cost of employee turnover for a company).
|Environmental Conservation of the natural world||Social Consideration of people & relationships||Governance Standards for running a company|
|Climate change & carbon emissions||Customer satisfaction||Board composition|
|Air & water pollution||Data protection & privacy||Audit committee structure|
|Biodiversity||Gender & diversity||Bribery & corruption|
|Deforestation||Employee engagement||Executive compensation|
|Energy efficiency||Community relations||Lobbying|
|Waste management||Human rights||Political contributions|
|Water scarcity||Labour standards||Whistle-blower schemes|
(Source: ESG Investing and Analysis, by CFA Institute)
ESG metrics reporting is not mandatory under the current financial reporting standards, just yet! However, companies are increasingly making disclosures in their annual report or in a standalone sustainability report. It should not be long before financial reporting standards catch up. The IFRS Foundation has begun a project on ESG by seeking input on whether there is a need for an internationally recognised ESG standards, and whether it should play a role and scope of its role in developing such standards, through the issuance of its recent Consultation Paper on Sustainability Reporting.
ESG in Business Valuation
One of the key challenges is how to integrate the ESG factors in business valuation, an area which is still under development. Let us look at two of the common and traditional valuation approaches – market and income, from an ESG perspective, which is also detailed in the paper ESG and Business Valuation by IVSC and ESG Factors for Equity Valuation by CFA Institute.
The Market Approach
While ESG data and disclosures are becoming more standardised for public companies, most companies that are the subject of valuation exercises are private. To account for ESG factors a valuer will be required to:
- Identify and assess the relevant ESG criteria for the comparable companies of the subject company and the industry it operates in;
- Assess the performance of the subject company for such criteria; and
- Calibrate the market inputs (for example, transactions / earnings multiples (such as EBITDA and Net profits)) to the subject company to consider the relevant performance as compared to its comparable companies.
At first, this process appears daunting. However, such a process is similar to existing procedures in which a valuer must:
- Understand the size, risk, future growth, business comparability, etc. of the comparable companies;
- Assess the performance and characteristics of the subject company in terms of its history, historical and forecast results, business plan, its prospects and risks; and
- Calibrate the market inputs to the subject company to take into account the relevant performance as compared to the comparable companies.
By integrating ESG considerations into the existing market approach procedures, the valuation task becomes more practical and manageable.
The Income Approach
While the income approach requires similar calibrations as the Market Approach, to compare the performance and characteristics of the subject company to that of the comparable companies, the greater reliance on future expectations and its explicit consideration in the financial forecast/ projections does add an additional layer of complexity to this approach.
For example, it is common practice to include a risk premium to the discount rate (or discount to the comparable company multiples in the case of Market Approach) to account for the relatively smaller size of the subject company. These risk premiums are supported by historical analysis that shows a statistically higher rate of return for smaller companies as compared to larger ones. However, an examination of criteria often cited as the rationale for the existence and magnitude of size premiums used in the discount rate derivation, shows overlap with what many would consider to be “ESG” factors. As such, current practice may partially account implicitly for some of the risk calibration of ESG factors from large public comparable companies to that of a smaller private company, i.e., the subject of the valuation. This represents just one example of potential overlap, as multiple other aspects of the income approach will require specific consideration, including:
- Beta – A reliable output from the Capital Asset Pricing Model (CAPM) requires the identification of sufficiently comparable public companies. As with the market approach, ESG characteristics may need to be added to the current framework for comparable company screening and identification.
- Long-term Growth – A core concept of ESG investing is to acknowledge that not all companies have the same structures in place to drive long-term sustainable growth. As such, a blanket reliance on standard long-term growth rates, with only minor consideration of industry and/or geographic growth rates, is likely to be insufficient. In fact, evidence suggests that ESG criteria is strongly correlated to long-term survivorship likelihoods, with a positive impact on the long-term growth rate. Given the low interest rate environment in the current COVID19 pandemic, valuations have become extremely sensitive to the long-term growth rate assumption. In addition, for low-performing ESG companies, many may argue that a long-term rate of decline, rather than growth, may be more appropriate.
- Company specific risk (or the Epsilon/ Alpha) – Adjustments for additional risk in the cash flow projections requires detailed consideration. Understanding the ESG profile of the subject company, comparison to the comparable public companies used to derive other inputs to the analysis (i.e., Beta), and interplay with projected cash flows, are all potential areas for consideration.
These considerations are highly technical and involve complex issues to be addressed and as such require additional deliberation for any ESG framework.
Another way of integrating the ESG factors in the income approach is by adjusting the future cash flows of a company. Take the BP oil spill in the Gulf of Mexico in 2010 as example. Not only did the spill result in fines for the companies involved, but it also led to disruption of production and operations and stricter (hence more expensive) safety measures in the years thereafter. All of these impacts have an effect on future cash flows that can and should be integrated in the financial forecast/ projections.
The key advantage of this method is that it forces the relevant company’s management to translate the company’s ESG factors into future cash flows and thus to focus on the relevant material issues. However, it is understandably difficult to estimate cash flow impact on low-probability, high-impact events, such as an oil spill, or to try to assign monetary value to ESG factors for which there is no market, such as governance factors. Still, this way of integration provides a much better starting point for discussion because the assumptions used are clearer than those made in the discount rate adjustment. It would also help in the subject company management’s attention and thought process from a shareholder value perspective – adding or reducing due to the ESG factors.
Often, trying to translate ESG factors into future cash flows with a high degree of conviction, due to multitude of factors to be considered and no ready benchmarks, is challenging. As such, valuers need to look at the sensitivities of the ESG factors to the overall valuation and consider different scenarios. These steps will help the investors, or the user of the valuation, gain better insights into the materiality and potential impact of ESG factors on the overall valuation. For example, for companies that have a more binary ESG risk (in other words, fewer options), one could look at a “business as usual” scenario and a scenario in which the ESG issues materialise. Both scenarios could be probability weighted to come to the valuation for the subject company.
ESG factors are gaining traction in business valuation analysis and are expected to represent fundamental and necessary considerations in the years to come. The first step is to begin with incorporating ESG considerations into valuation practice which are critical for the relevance, and therefore the sustainability, of the business valuation profession.
In addition, the business owners should also pay attention to the ESG factors they may have encountered in normal course of business. Business valuation incorporating the ESG factors can go a long way for business owners to understand how to use it for its potential business benefits and potentially growth, as well as for business sale, particularly to larger or listed companies, and compliance with financial reporting standards in the future, as this area develops.
By Nai Siu Loon
This article has been authored by Nai Siu Loon, the Co-Founder and Associate Director of Spring Galaxy.