Impact of ESG factors on business valuation

ESG factors are increasingly gaining importance among companies, investors, and business valuation specialists. The crucial factor for reporting and ultimately also for the analysis of ESG factors is their measurability. All over the world, various service providers have already developed or published so-called ESG scores or ratings. Although the definitions of the respective ESG criteria and the guidelines how to measure them are continuously being standardised and enhanced, they lack an overall distinct explanatory power due to the huge number of providers of ESG scores emerged by now and the wide range of measurement approaches. Furthermore, the availability of such metrics and the result often depend on the size of the company. 

Heterogeneous information and yet an objectifiable business valuation - how can that work? This article aims to briefly discuss and critically comment on the process of considering ESG factors in business valuation.

Generally, when performing a business valuation with regard to ESG, it is important to identify the relevant risks and opportunities for the business model of the company to be valued. ESG ratings, corporate and sustainability reports as well as analyst evaluations can be used as sources. The impact of the identified factors on the operating business, financing, and cash flow should then be assessed and quantified for each company on a case-by-case basis.

The increasing relevance of ESG implies that ESG factors should be included in the valuation process from the very beginning. As part of a DCF or income approach, it should first be assessed to what extent the ESG risks and opportunities identified by the valuation specialist have already been considered in the company's business plan. This is often difficult, but essential in order to avoid double counting. If ESG factors are not included yet, the planned cash flows should be adjusted accordingly. For example, a reduction in sales revenue due to poor reputation, an increase in taxes due to legal requirements or increased CAPEX to reduce ESG risks could be taken into account. 

In addition, it is possible to add risk premiums to the discount rate applied. The first step is to identify the drivers of the business model and their risks in connection with ESG factors. An analysis of the comparable companies (peer group analysis), which includes the relevant ESG criteria, can be used to derive a company-specific risk factor, which in turn is incorporated into the appropriate discount rate. This risk factor is intended to reflect fluctuations in returns due to ESG opportunities and risks. For example, companies with a poor ESG score have, on average, a higher risk profile and thus a higher discount rate, which again leads to a lower enterprise value in the DCF analysis.  

However, ESG factors can also be integrated into market-oriented valuation approaches (e.g. multiple analysis). Within a multiples analysis, ESG criteria for the respective industry first needs to be identified and assessed, and can then be compared to the ESG performance determined for the target company. Based on this assessment, the valuation parameters (e.g. market multiples) are adjusted to the target company in order to consider the relative performance of the company compared to the peer group. This process of including ESG factors deviates only marginally from the traditional multiple valuation process and therefore can be easily integrated into the business valuation.

Currently, there are various opinions on the influence and application of ESG factors in business valuation. One major source of criticism is the often challenging measurability of the respective criteria as well as the lack of uniform metrics and scales. The impact of ESG factors on the enterprise value also depends on whether one assumes that this factor has already been priced into the expectations of the market or not. Because of the relatively short observation period, it is difficult to determine the extent to which the market has already priced in the ESG effect. The causality between the performance of investments and their ESG rating cannot yet be fully established.

Therefore, the relationship between profitability and ESG ratings of a company must be critically challenged. In general, it seems to make sense to attribute a higher profitability and thus a higher enterprise value to a company with a good ESG rating - after all, it appears to be well prepared for the future. The question is however whether "good" companies are indeed more profitable or whether profitable companies have a good ESG rating because they are able to invest more in measures that improve their rating. It will only be possible to answer this question after a longer period of analysis when it is possible to make appropriate statistical evaluations.

Overall, it should be assumed that incorporating ESG factors into the valuation process can make a company's profile more transparent and thus deliver more comprehensive findings. However, due to the lack of standardisation, insufficient data, and an unclear correlation between ESG factors and a company’s returns the findings currently still involve a lot of uncertainty. 

Nonetheless, taking into account ESG factors, both for the operational planning of companies and for company valuations, should not be overlooked as it will become increasingly important in the future.