Increasing Importance of ESG Factors in Business Valuation

ESG compliant investment opportunities were once limited. But today, most companies in developed nations have ESG standards woven in some part of their operations. The shift has come about because investors are demanding transparency on environmental issues like carbon emissions and a company’s ESG rating.??

ESG standards can influence a company's profitability because investors as well as consumers are expecting companies to act in a responsible manner towards the environment as well as the society. There’s a rising trend among investors to avoid companies that lack ethical practices. Younger generations are even more environmentally conscious and committed to a sustainable future.

In this article, let’s find out how ESG affects valuation and influences businesses.?

ESG’s Evolving Role in Business Valuations

Before we get into the details, let’s understand what “E”, “S” and “G” individually represent:

Environment ?tackles the question: “How does a company use natural resources and handle emissions?”

Social tackles the question: “How does a company engage with its stakeholders and their broader community?”

Governance? aims to answer: “How does a company carry out its corporate conduct while managing environmental and social factors?”

ESG has been accepted internationally and many companies use it in their operations., Sadly, the framework for integrating ESG into business valuations is still in very early stages. The International Valuation Standards Council states that ESG should be factored into existing valuation methods like the DCF or the comparables method instead of using basic “price x quantity” methods.?

Let's see two ways it can be done:

Market Approach:

To factor in ESG considerations under the market approach, companies can use a comparables approach:

1. Identify the ESG practices within similar companies and industries.
2. Review the subject company’s performance on these ESG criteria.
3. Finally, adjust the market inputs for the subject company to reflect its relative ESG performance compared to comparable companies.

Income Approach:

To incorporate ESG factors under the income approach- you can adjust the discount rate or the cash flows.

The factors taken into consideration while adjusting? the discount rate are alpha (the risk premium of risks other than market risks) and beta (volatility of the stock in comparison to the market). Make sure that the beta doesn’t already account for ESG factors beforehand to avoid double counting.?

The second method involves adjusting the future cash flows. It allows investors to concentrate on the most relevant issues. The impact of ESG factors on cash flow adjustments can differ from one industry to another and is heavily dependent on the company’s performance as well.?

In such scenarios, it is better to adopt an industry-specific lens. For example:

• Environmental factors can be reflected by adjusting cash flows for additional costs incurred during carbon reduction initiatives.

• Social factors could be incorporated by adjusting costs related to employee training, costs incurred to improve workplace safety, and R&D investments to ensure product quality.?

• Governance factors can be included by accounting for fines from governing authorities due to bad governance practices.

Since ESG factors or events are unpredictable, a sensitivity analysis can also be done to evaluate different scenarios to understand the impact on valuation.

ESG’s Influence on Business Valuations?

Here’s how a strong ESG compliance can contribute to long term value creation for businesses:

• Consumers these days incorporate social and environmental values when making purchases. Adhering to ESG standards can lead to higher brand loyalty which further leads to revenue growth.

• By adopting renewable energy and managing resources sustainably, businesses can lower their operating costs. It directly supports profitability and strengthens the company’s financial foundation.

• Companies proactive about ESG compliance face fewer regulatory challenges and have to pay low or no fines.

• Companies with a strong ESG focus end up creating a nurturing work environment that attracts and retains highly talented people. It drives productivity, innovation, and builds a more resilient talent pool.

Investment and Capital Opportunities

Investors favor companies that are committed to sustainability. A strong ESG record attracts new funding avenues, and can reduce borrowing costs. As a result, they achieve higher valuations compared to companies with poor ESG performance.

Investors are looking at business models through the lens of ESG and evaluate the following factors before investing in a company:

• The company should have a business model that can withstand challenges related to climate change and changing regulations around it.

• The company’s social policies and practices should be designed to attract and retain customers and talent.

• The governance structure should have the capability to manage risks or unforeseen challenges in the long term.

Incorporate ESG into your Valuations with Eqvista?

Companies that prioritize ESG factors are actively working to improve the areas of environment and community they use and serve respectively. It improves the company’s valuation directly or indirectly giving them a competitive edge in a rapidly changing business landscape.

Eqvista can help you get your company's valuation within minutes.?

All you have to do is answer our questionnaire designed around your company's management, sales, and marketing. Once you complete the questionnaire, our software produces a valuation summary and provides a convenient snapshot of your company’s worth.

This valuation summary comes in handy if you want to secure funding, attract investors and venture capitalists, and win new projects.?Contact us to know more!