When integrating ESG factors into investment analysis, they are examined alongside other valuation drivers. It has been more common to process ESG factors through qualitative analysis, but investors are increasingly also quantifying and integrating ESG factors into financial forecasting and company valuation models, in alignment with other financial factors.
Overview of fundamental strategies
Fundamental investors identify investment opportunities by using company data to make assumptions about future performance. These assumptions are based on qualitative and quantitative analysis of economic trends, the competitive environment, the market potential of a company’s products and services, operational management and the quality of senior management. They use investment research and financial data from multiple sources, and often meet senior management teams.
They will then build or update company valuation models to assess a company’s perceived intrinsic value and compare this to its current share price, thus identifying companies they think are over-valued and under-valued by the market.
Alternatively, and in combination, some fundamental managers use the relative valuation approach: they compare a company’s financial ratios – such as price-to-earnings (PE) and return on invested capital (ROIC) – to its peers and/or the sector’s average, to assess whether the company is relatively fairly valued, undervalued or overvalued.
Forecasted company financials drive valuation models such as the discounted cash flow (DCF) model, which in turn calculates the estimated value (or fair value) of a company and hence can affect investment decisions. Investors can adjust forecasted financials such as revenue, operating cost, asset book value and capital expenditure for the expected impact of ESG factors.
Income statement adjustment – Revenue
Future revenues and revenue growth rates have a significant impact on the fair value of a company as well as on other related variables (e.g. estimated future operating expenses can be calculated as a percentage of sales, and estimated future depreciation charges can be calculated by multiplying sales by a ratio of average historical depreciation to sales).
To forecast revenues, investors will typically take a view on how fast the industry is growing and whether the specific company will gain or lose market share. ESG factors can be integrated into these forecasts by increasing or decreasing the company’s sales growth rate by an amount that reflects the level of ESG opportunities or ESG risks.
For example, a carmaker may stop selling a particular type of car in a particular country due to environmental concerns, which is estimated to reduce sales by X% annually, or rising obesity could be a revenue driver for a retailer in health, wellness and diet products, which is predicted to increase their sales by X% over the next five years.
Income statement adjustment – Operating costs and operating margin
Investors can make assumptions about the influence of ESG factors on future operating costs and either adjust them directly or adjust the operating profit margin. Some operating costs may be forecast explicitly, for example the change in number of employees, but depending on the level of disclosure by companies, it may be necessary to make an adjustment to the operating margin instead.
For example, a manufacturing company’s operating margin may be reduced to reflect the loss in production caused by high injury and fatality rates and poor health and safety standards, or a chemical company’s operating cost estimates may be increased by US$Xm a year for the additional cost associated with new legislation on toxic waste.
Balance sheet adjustment – Book value and impairment charge
ESG factors can influence assets’ anticipated cash flow, such as by forcing long-term or permanent closure, and therefore alter their net present value. The impact is most likely to be a reduction, resulting in an impairment charge being made to bring the book value down accordingly, and therefore reducing not only the asset value but the company’s earnings for the year in which the non-cash, oneoff impairment charge is recorded on the income statement. An asset revaluation can result in lower future earnings, a smaller balance sheet, additional operating/investment costs and a lower company fair value.
For example, the future cash flow from a mining company’s coal assets may be significantly less than the estimated future cash flow due to insufficient demand or regulatory change, or new technology could make it possible for a miner to extract commodities that were previously economically unviable.
Cash flow adjustment – Capital expenditure
An investor may believe that ESG factors will lead a company to decrease or increase their future capital expenditure. Investors would then either decrease or increase capital expenditure forecasts by adjusting the formula linking capex to revenue, or (if aware of specific expansion plans, such as new factories, shops or mines) by applying an one-off, absolute cost adjustment to the forecasted cash flow statement.
For example, legislative changes could force an electricity producer to upgrade its coal power plants to meet new environmental regulation, or a manufacturer may see a recycling opportunity that requires a new production facility.
Company valuation models
The company valuation models that managers use to value a firm – including the dividend discount model, the discounted cash flow model and adjusted present value model – can be adjusted to reflect ESG factors.
Some models require calculating a terminal value for a company (the estimated value of the company at a point in the future assuming the company generates cash flows indefinitely), which is then discounted back to current day. A positive terminal value will increase a company’s fair value.
ESG factors could cause investors to believe that a company will not exist forever, for example if an oil and gas company’s assets are considered stranded and there is doubt over the sustainability of the business model. In this instance, the terminal value can be zero.
Beta and discount rate adjustment
Some investors adjust the beta or discount rate used in company valuation models to reflect ESG factors: corporate governance, operational management, general quality of management, its strategic decision making etc.
One approach to adjusting the beta or discount rate is to run a peer analysis of companies within the sector and then rank them using ESG factors. An investor can then increase/ decrease the beta/discount rate for companies considered to possess high/low ESG risk, in turn reducing/increasing the fair value.
A common approach used by investors to understand the impact of ESG factors on the fair value of a company is to conduct a scenario analysis, where an ESG-integrated company valuation is calculated and compared to a baseline valuation. The differences between the two scenarios very clearly depict the materiality and magnitude of ESG factors affecting a company.
A practical guide to ESG integration for equity investing
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