The role of ESG factors in business valuation

The pursuit of ESG objectives by a company does not necessitate any specific methodological approach to 

valuating the company. However, it does require careful consideration of factors that were previously not fully appreciated, but which must also be properly examined on the basis of appropriate ESG disclosure.

The latest studies and research show that ESG factors affect company valuation in three main ways:

The integration of ESG factors at company level can generate tangible benefits for a company, leading to improved cash flow and growth factors (g).

The main impacts can be seen in terms of revenue growth, cost reduction, operational efficiency, increased productivity and optimisation of investments. The adoption of sustainable practices may result in consumers being willing to pay a premium price for environmentally friendly products. Additionally, the use of environmently low impact technologies results in a reduction in operational costs. Furthermore, a work environment where ESG values are emphasised and internalised ensures enhanced productivity while attracting and retaining talent.

A study conducted by the International Valuation Standard Council (2021) found that the value created by ESG factors has similar characteristics to the return on investments made by intangibles in terms of sedimentation, that is cumulative growth.

The implementation of ESG policies often requires significant upfront investments, given that the benefits will only be seen in the medium to long term. It is therefore essential to conduct a careful and meticulous risk analysis and a thorough assessment of operating conditions.

Scholars have conducted a thorough analysis of the influence of ESG factors on systematic risk, which is expressed by the Beta factor which is part of the Capital Asset Pricing Model used to determine the cost of equity (Ke).

It has been observed that companies which follow ESG practices are generally more resilient to regulatory pressures and external changes. This is because they are better able to manage risks that are not expressed in cash flows, such as regulatory risk, reputational risk and transition risk itself.

Kroll's 'ESG and Global Investor Returns Study' (2023) analysed the returns associated with ESG portfolios used to calculate the systematic risk of a security, i.e. the Beta factor. The research demonstrated that companies with robust sustainability policies and high ESG scores generally exhibited higher compound annual returns than those with lower scores. Additionally, the analysis revealed that these securities exhibited lower volatility compared to the market, as reflected in their Beta parameters.

The research findings indicate a correlation between the implementation of the ESG policies, returns and stock volatility of the companies concerned across most geographic regions and sectors, at least for the period under analysis (2013-2021).

Another noteworthy aspect is the asymmetric market reaction to ESG information. Companies with poor ESG practices tend to face higher penalties than those with positive practices. This highlights the growing importance of sustainability policies in the market and the need for greater attention at corporate level to prevent events that could erode investor confidence.

Good ESG practices can positively influence access to credit. By enhancing their ESG disclosure, companies can mitigate information asymmetry and subsequently reduce their cost of debt (Kd). This can result in more favorable ratings and a decrease in perceived risk for lenders.

Further advantages of ESG disclosure include the strengthening of relationships with financial stakeholders, which ultimately results in enhanced access to debt at competitive rates for companies with superior ESG scores.

However, these benefits do not always materialize. In some cases, lenders view costs associated with such initiatives as not being directly related to the core business and consequently charge higher interest rates to compensate for the perceived risk. This phenomenon is particularly prevalent in the case of SMEs, where the ESG reporting system is less structured.

While the three ESG factors are interlinked, they do not all carry the same weight. The environmental (E) dimension has a more direct impact on economic value. For example, initiatives such as decarbonisation or waste reduction improve efficiency and reduce operating costs. The social (S) and governance (G) dimensions, while having less immediate impacts, are nevertheless crucial for corporate reputation and risk management. For example, strong governance reduces the risk of litigation or an inefficient decision-making process.

In light of the above, it is evident that a company valuation must take into account ESG factors and their influence on a company's value (in terms of cash flow, growth rate, beta factor and cost of debt) on the basis of a case-by-case analysis.