Many investors already have some form of ESG criteria when valuing investments; a trend that is only going to get stronger as more reliable data becomes available, and regulations and standards are refined.
There is anecdotal evidence that a business that is actively reducing emissions will achieve a higher PE multiple than one that isn’t. There's also increasing evidence that private equity investors will pay more for businesses with a compelling ESG story, potentially up to 10 percent or 20 percent more based on recent evidence, from our recent mid-market private equity report.
So, what are the main areas to focus on when looking at the impact of ESG in valuations? Here are five things you need to know about ESG in valuations:
1) The knowledge gap
Although its importance has increased dramatically over the past five years, the application of ESG metrics in financial analysis is still developing. This creates a number of challenges.
- First, is the lack of a consistent framework around collecting, measuring and reporting ESG data. This makes comparisons between businesses – a key component of the market multiple approach – very difficult. Added to this challenge are the sometimes-conflicting ESG ratings provided by various agencies.
- Second, is the lack of a standard methodology for incorporating ESG data and translating these into financial measures, increasing subjectivity in valuation analysis. Frameworks are being developed and proposed, including the International Valuation Standards Council and A4S (Essential Guide to Valuations and Climate Change), but the work is still in progress and there is, as yet, no single universally accepted approach.
- Third, is a lack of expertise. Although many ESG factors may appear to be common sense, significant upskilling is required for the understanding of and incorporation of ESG factors into valuations and appraisals to become commonplace.
2) Protecting vs. creating value
Put simply, value is created by enhancing cash flows or reducing risks by maintaining or protecting value. If ESG risks are not managed or mitigated, value is likely to be eroded over time. Whereas taking a more active approach on ESG can help you become a leader in the market, with knock-on benefits in terms of recruitment and retention, brand perceptions, and supplier relationships, for example.
In thinking about ESG factors in a valuation, the ‘G’, governance, protects value in an asset or business, whereas investing in the ‘E’ and the ‘S’ opens up opportunities to create value and build longer-term competitive advantage. You need to consider how these factors will impact the financial performance. For example, exposure to climate risk may have a long-term impact on disruption to supply chain, therefore increasing operating costs. In contrast, adhering to higher labour standards will increase opex in the short term, but it may generate longer term value from better workforce retention and stronger customer/client relationships. Similarly, would investing in greener technology today give the firm a competitive advantage in future which enhances profitability?
3) Assessing ESG factors in valuation
There isn’t a 'one size fits all' solution for assessing ESG factors in valuation, but under the common valuation approaches, the current preferred method is to make explicit adjustments in cash flow forecasts where possible.
One approach is to use an assessment framework to identify ESG risks and opportunities material to the business and determine whether these are internal or external factors (e.g. specific to the company / asset or systemic), short or long term, their materiality, their measurability, and so on. This matrix can be overlayed on other more traditional valuation considerations to assess the adjustments required to cash flow or, if appropriate, the discount rate. The assessment needs to be an interactive and iterative process involving the management of the subject business.
4) Using ‘what-if’ analysis
There are likely to be factors that can’t really be quantified. So the next best approach is to use scenario or 'what-if' analysis to help determine the impact should the conceived events materialise. This is particularly helpful when it comes to assessing climate risks. But challenges remain as to what a “base case” climate scenario would look like for valuations purposes, as currently there is not a set of commonly accepted assumptions. Almost by definition, climate risks will bring very little upside, but by taking action you are protecting value, thereby protecting the return for investors.
One issue to be aware of is double-counting of risks and opportunities. Some ESG risks are systemic and others are idiosyncratic. Some are long-term, others are short term. If using an income approach, adjusting for systemic risk in the cash flows needs to be considered in conjunction with the inputs in the discount rate (e.g., risk free, beta and Market Risk Premium) you apply. Or if you are applying a market approach, decide if it warrants an additional adjustment for systemic risk, considering the comparable company multiples are exposed to similar systemic risks.
With more data and disclosure emerging from companies and transactions, more accurate calibration, and analysis of correlation between, for example, ESG scores and financial metrics will enable more robust valuation analysis. We expect this will also lead to a more noticeable gap in valuations between the frontrunners and laggards on ESG strategy.
5) Time horizon
It’s important to consider the timing of these ESG risks and opportunities. For example, climate transition risks are expected in the short to medium term as economies and companies transition to net zero, while physical risks are expected to impact in the longer term.
Currently, the discounted cash flow approach assumes perpetual growth or an exit as a proxy for the terminal value. Taking into account longer term impact may suggest an adjustment to the terminal growth rate, or the exit multiple, is required. With a significant proportion of value often attributed to the terminal value, this could make a big difference.
If applying a market multiple methodology, the typical approach would be to consider applying maintainable earnings to a market multiple. However, you need to consider what ‘maintainable earnings’ actually means in this context. Particularly in light of the risks arising from, for example, transition and physical risks or social risks, such as relationships with employees or suppliers which may lead to longer term increase in operating costs for the business.
Factoring ESG into valuation is now a necessity
Having a robust ESG strategy that both protects and creates long term value will be a vital component of value. Investors and providers of capital want to maximise returns on their investments. Companies with no ESG strategy, or a weak one, will increasingly find their options limited as these providers of funds demand evidence in monitoring and performance in various ESG factors. This will impact the growth opportunities of a business, and therefore its value. By not taking ESG factors seriously, businesses are not only leaving value on the table, they are also increasingly leaving their long term viability in the balance.