ESG and company valuations – hype or “new” standard

published on 15 november 2023 | reading time approx. 2 minutes

The “hype” surrounding the term ESG often assumes that there is an automatic increase in value by taking ESG into account. In particular, flat-rate premiums or discounts (if not taken into account) on valuations are often discussed. This falls short of the mark. Value can only be implied by analysing the expected cash flows and the impact of ESG on the cost of capital in detail. The considerations that can be made in this context are briefly described below

When analysing cash flows, the following examples of ESG influences (not an exhaustive list) should be taken into account:

Operating costs and efficiency: Companies that introduce environmentally friendly practices to increase energy efficiency, make better use of resources and reduce waste can lower their operating costs. This can lead to higher operating cash flow
Reputation management: Companies with a good ESG reputation are often better able to attract and retain customers and employees. This can lead to greater pricing power (see organic food or sustainable clothing) and thus more resilient or rising sales and larger market shares, c.p. enabling an increase in cash flows. It is also assumed that compliance with ESG standards is necessary to avoid employee turnover.
Regulatory influences: Changes in environmental and social regulations can have an impact on a company's business practices and, in particular, its costs. Companies that consider and adapt to these developments in advance can better manage their cash flows and, in particular, avoid potential fines or regulatory bans.

It is important to note that the impact of ESG on cash flows can vary depending on the industry and company structure. Companies that integrate ESG into their business strategy and view it as a long-term investment often have a better chance of benefiting from the positive impact on cash flows.

In addition to the cash flow, ESG factors can influence a company's cost of capital (equity and debt capital costs).

While no clear correlation between equity costs and ESG factors can be derived (e.g. due to a lack of reliable data points), the positive influence on debt financing costs is evident in the following points:

Lenders, including banks and bond investors, are increasingly taking ESG risks into account when granting loans. A company with a demonstrably poor ESG performance could be categorised as riskier, which can lead to higher borrowing costs.
Risk mitigation: Companies that effectively identify and manage ESG risks can convince lenders that they are well positioned to minimise potential disruptions or losses or are prepared for environmental disasters. This could help to reduce the cost of debt capital due to strategic risk provisioning.
Green bonds: Some companies use ESG-related financing instruments such as green bonds or sustainable loans to finance projects with a positive environmental impact. These instruments may be offered on more favourable terms as they are specifically geared towards sustainable initiatives.

ESG ratings are regularly used to objectively quantify the impact of ESG activities on a company's borrowing costs. These allow a comparison to be made between the company being valued and reference companies and thus enable a simulation of possible influences on borrowing costs.

It can therefore be summarised that the consideration of ESG factors can have a positive influence on cash flows and a reduction in the cost of capital. It can therefore be hypothesised - and this has to be validated in individual cases - that an increase in value is possible by taking ESG factors into account.

Considering the large number of discussions and contributions on ESG issues, we assume that an appropriate corporate valuation cannot be carried out without analysing the ESG factors described above.