Today, ESG factors have gained more importance in the capital allocation process for both the providers of capital i.e., investors and companies, being the users of capital. However, there is still a common misconception that ESG disclosures are typically non-financial in nature and therefore do not have a financial impact.
Furthermore, to date, there was a lack of uniformity in ESG ratings, disclosure requirements and standards which makes it difficult to capture the value creation impact of ESG in company valuations.
Having said this, investors today consider whether a company:
- [E] Has a business model facing threats from climate change and regulation;
- [S] Has in place social policies capable of attracting and retaining customers and employees; and
- [G] Has a governance structure capable of sustaining unforeseen challenges.
Therefore, ESG factors are commonly referred to as pre-financial information and failure to thoroughly account for such information in the valuation process fails to account for much of the market value.
The below are our insights how a valuer can incorporate ESG factors into the company valuations.
ESG data, including ratings and disclosures, is more standardised and available for public companies. Therefore, when carrying out a valuation of a private company, the valuer should identify and assess the relevant ESG criteria of the comparable companies, the peers. The company being valued is then assessed against such criteria for the valuer to substantiate an adjustment to the multiples used.
The idea behind ESG investing is that if significant capital is flowing to companies that are considered “good” ESG citizens, they should be able to raise capital at a lower cost. A lower cost of capital results in higher present value of future cash flows. Therefore, for a company which scores ‘poorly’ when its performance is assessed against such ESG criteria, the valuer would apply a discount to the peers’ multiples. The valuer must pay special attention to avoid ‘double counting’ for specific risks.
This method relies on the future expectations of cash flows and therefore adds another level of complexity in incorporating ESG factors. Adjusting future cash flows is challenging but gives more visibility related to the impact of an ESG factor. Having said this, the valuer needs to keep in mind that some ESG factors are likely already incorporated into valuations indirectly. An example is the common risk premium added to the discount rate for small companies which may incorporate some ESG risks.
Reach out to us if you need assistance with your ESG strategy or interested in gaining an understanding how the value of your company can change by embracing ESG.