ESG, which stands for Environmental, Social, and Governance (ESG), has become one of the key criteria in the evaluation process, when assessing potential investments. Under the three ESG areas, a set of standards, is used to evaluate the organisation’s operations.  It is unlikely that an organisation scores the best in all ESG criteria.  Investors take the outcome of the evaluation and incorporate it both qualitatively and quantitatively into their decision making.

Although ESG and related performance of organisations has been included in mainstream investment decisions for more than a decade, an area which is still evolving is how ESG should be quantified and included in the business valuations. To understand the significance of including ESG impact in the valuation, let’s look at the two main traditional valuation methods – Discounted Cash Flow (DCF) method and Multiple of Earnings method.

Discounted Cash Flow method

Under the DCF method, the Free Cash Flows of a company are discounted with the expected cost of capital to arrive at the valuation. In simple terms, Free cash flow (FCF) is the money a company has left over after paying its operating expenses and capital expenditures and Cost of Capital represents the risks related to the cash flows.

ESG impact can be included in either of the two main components, namely Free Cash Flow and the Cost of Capital, to influence the business valuation.  By doing this, the positive or negative impacts of ESG criteria evaluation, on the future cash flows of the company, and hence its valuation can be considered.  For instance, in the case of a company with higher ESG risks, cash flows can be adjusted down, or cost of capital can be increased, and vice versa. Often in making such adjustments, one need to consider the materiality of the impact of the relevant ESG criteria.  The materiality would be specific to the company and its industry. To reduce the subjectivity involved in determining the materiality, analysis of multiple scenarios and techniques such as weighted average analysis should be used.

Multiple of Earnings method

Under the multiple of earnings method, the value of a company is determined by applying a multiple to the company’s earnings. It is a relative valuation method and seeks to evaluate similar companies using the same set of standardised financial metrics. A commonly used multiple is Price-to-Earnings (P/E) multiple.

ESG impact can be included in the multiple used for the valuation.  The impact of ESG criteria results in a higher or lower multiple, relative to those achieved in comparable transactions.  For instance, a Private Equity buyer who considers the impact of ESG criteria, and the resulting risks and/or opportunities during the due diligence phase can optimise the price paid. Similarly, a corporate seller, doing a divestment of a non-core asset, can effectively use the positive impact of ESG criteria on the company’s operations, in influencing a higher valuation multiple for the transaction.  

As mentioned previously, multiples are influenced by the prices achieved for transactions involving comparable transactions in the market.  There is not yet full transparency regarding the influence of ESG criteria in both public and private transactions.  Hence there are limitations in identifying comparable transactions which included ESG criteria or the level of inclusion of ESG criteria.  In addition, there is the risk of arbitrary adjustments to the multiple.  As more data becomes available, inclusion of ESG criteria in multiples can be further refined.

The inclusion of ESG criteria in business valuation has gained more prominence recently.  There are several ways ESG is incorporated in the valuations, and it continues to evolve.  As more instances of ESG application in valuation becomes available, across various industries and geographies, best practice models are expected to emerge.