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Seizing the ESG criteria into valuation analysis

Seizing the ESG criteria into valuation analysis

Regulatory evolutions such as the Corporate Sustainability Reporting Directive (CSRD) are confirming the integration of ESG factors into non-financial information. How will this help valuation professionals in quantifying ESG factors? Christophe Vandendorpe and Elena Moisei from EY Luxembourg share their views.
Christophe Vandendorpe, Partner, Strategy and Transactions Leader, EY Luxembourg, Elena Moisei, Senior Manager, Strategy and Transactions, EY Luxembourg
Christophe Vandendorpe, Partner, Strategy and Transactions Leader, EY Luxembourg, Elena Moisei, Senior Manager, Strategy and Transactions, EY Luxembourg
Photo credit: Photo : EY Luxembourg
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ESG criteria quantified in valuation

The recent pandemic reinforced the importance of developing an ESG framework reaching beyond basic corporate social responsibility criteria, its incorporation into the financial performance, and its consideration in the valuation process. Several international financial bodies have launched global initiatives to form the milestones of a more homogeneous regulatory and reporting framework through ESG lenses. While being developed, measurement and reporting of ESG performance by corporates still requires standardisation to enable valuation professionals to capture and quantify ESG factors into the valuation analysis of private companies. This raises the question within the professional valuers’ community: How do we quantify ESG “quality” into valuation analysis?

The International Valuation Standards Council (IVSC) and its ESG Working Group are actively involved in creating a favourable framework for the incorporation of ESG related factors into the valuation process. In its efforts to address valuation challenges driven by the COVID-19 pandemic and assessment of ESG factors into the valuation analysis, the IVSC has issued a perspective paper “ESG and Business Valuation” in March 2021. According to IVSC there is a view that ESG disclosures are typically non-financial by nature, and therefore do not have a financial impact.

Which approach will you choose?

While recognising that this is only a limited perception, ESG criteria could be seen as “Pre-financial” rather than “Non-financial” information. This assessment would form a first step in integrating the ESG criteria into financial information and ultimately into valuation analysis. The main accountability factors will be considered in both the market and income approaches.

In the Market Approach, a 3-step approach is suggested by the aforementioned IVSC paper, i.e., 1) assess the relevant ESG criteria for a given sector, 2) compare the performance of the subject company to such criteria and 3), calibrate the valuation parameters (such as market multiples) to the subject company, to consider its relative performance against market peers based on selected ESG criteria. This approach would therefore not differ significantly   from the traditional process of applying market multiple valuation techniques. Hence, with the further development of reporting frameworks, valuers will undoubtedly integrate ESG factors in their valuation process.

In the Income Approach, the challenge of ESG criteria assessment comes from the reliability of future cash flows and inherent risks of management to achieve their forecast. Indeed, the consideration of ESG factors into the valuation is in an early stage, however several factors are already measured by professional valuers into valuation analysis (e.g. specific risk premia / discount in the discount rate). An important point of attention is avoiding to double count such ESG valuation impacts. Indeed, company’s management consideration on ESG risks and opportunities may or not be already reflected in its business forecast plan, whereas the valuer will focus on appropriately assessing risk premia in its discount rate. Hence, the valuer will need to assess to what extent the subject company’s forecast data integrates the risk and opportunities within its projections.

To determine the discount rate, professional valuers use models such as the Capital Asset Pricing Model (CAPM). In that context, the valuer identifies reliable comparable public companies. Similar to the market approach, valuers will have to add new screening criteria and specifically assess the selected comparable for ESG characteristics. Hence, valuers will not only have to rely on well-known factors such as macroeconomic growth rates (e.g. inflation rates, GDP growth rates), but also assess long-term ESG risks and ESG opportunities. This means that, ultimately, low-performing ESG valuation entities may be subject to long-term rates of decline rather than long-term growth rates.

Secondly, the inputs of the discount rate may be further adjusted to take into account systematic risk such as Beta factor as well as specific risk factors such as reliability of projected cash flows in light of ESG considerations.

Sharing the responsibility between valuers and management

All these valuation adjustments related to ESG factors measurement will raise the complexity of valuation analyses and give new perspectives of seizing a qualitative factor into a quantitative analysis. As such, the question is how to split the responsibility between professional valuers and management of who will have to implement the “under construction” ESG metric standards across companies, industries, and locations?

Continuous integration of ESG criteria into valuation practice, will ultimately lead to more effective and transparent interaction between stakeholders, investors, and management. There is a momentum and market opportunity to go hand in hand with regulators to reach the milestone that will allow ESG factors to be incorporated in valuation analysis and ultimately reported on balance sheets.