Case study by RobecoSAM
To identify companies that are better positioned to create long-term value (and to demonstrate sustainability’s contribution to long-term corporate value), we:
- eliminate from the investable universe the companies with the weakest sustainability performance, based on the sustainability scores from our Corporate Sustainability Assessment (which is also used to determine the components of the Dow Jones Sustainability Indices (DJSI));
- identify the most promising companies, from both a traditional valuation and sustainability perspective;
- integrate sustainability information into financial models (economic value added model) and determine sustainability’s contribution to the company’s fair value.
Identifying promising companies
The sustainability analyst benchmarks the performance of companies in a given industry on the most material sustainability factors. In parallel, the equity analyst determines whether the return potential of the underlying business (as measured by the company’s return on invested capital) is reflected in the market price (as measured by the company’s enterprise value), or whether the company is trading at a discount and therefore represents a long-term buying opportunity.
Looking at portfolio company Infineon, as an example for the semiconductor industry, the most material factors include innovation management, human capital management, corporate governance, business ethics, supply chain management and environmental management. Compared to industry peers Infineon received a positive overall sustainability profile, driven by its superior performance in innovation management, sector-leading human capital management and excellent corporate governance practices. However, there is a small negative impact from business ethics due to antitrust issues.
Infineon also showed a superior return potential relative to the sector, but because this was already partially reflected in the share price, the stock ranks only neutral on the valuation screen.
Integrating sustainability into valuation
The equity analyst builds an economic value added (EVA) model, incorporating the information from the sustainability analyst by estimating the material sustainability issues’ financial impact on the business value drivers (growth, profitability and risk).
In the example of Infineon, the sustainability analyst suggested a positive impact on growth and profitability (driven by the strong capacity to innovate and the leading position in human capital management), and no impact on risk (WACC). Operational efficiency gains from environmental initiatives also increased the operating margin. With sustainability factors integrated, we applied an operating margin above the historic five-year average operating margin of the company, and assumed strong organic revenue growth. The negative impact on the risk profile from antitrust issues was off-set by proactive corrective actions around business ethics and the generally good performance in corporate governance, resulting in no adjustment to the risk assumptions.
To extract sustainability’s contribution to the overall fair value of Infineon, we applied an excess return model. In this model, the fair value with industry average returns applied is subtracted from the analysed company’s total fair value, leaving the excess returns, which are attributed to sustainability (figure 2). This is then split proportionally according to the respective sizes of the positive and negative impacts identified previously.
For Infineon, innovation management, human capital management, corporate governance and operational efficiency gains from environmental issues have a positive 4%, 3%, 2% and 1% impact on the fair value while business ethics has a negative 2% impact.
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A practical guide to ESG integration for equity investing