Do you want to know how to integrate environmental, social, and governance (ESG) data into business valuation? This book will help you do so step-by-step.
The book primarily aims at reaching two types of audiences: practitioners and students in finance (graduate and undergraduate level). Practitioners in finance will find interest in the book, as it will give them access to academic knowledge in a format that suits them. Academic research has made substantial advances in the field of business valuation and ESG. The book intends to transform this knowledge into practical and rigorous methodologies for taking ESG into account when valuing a company. Graduate and undergraduate courses have recently developed in business schools, universities, and engineering schools. These courses usually directly refer to academic articles or valuation companies' website documentation, but not to academic books. Therefore, the book will allow students to have access to centralized and organized information about business valuation and ESG.
Readers without prior knowledge of business valuation will be guided through the ESG integration process. They will first be introduced to the concept of value and the reasons for incorporating ESG into the value. They will then learn simple financial methods to value firms and see step-by-step use cases. For instance, the reader will learn how to value a firm in the renewable energy sector using cash flow and multiple valuation methods. After building knowledge of standard business valuation, readers will better understand ESG data and ratings. The reader will then learn how to integrate ESG into business valuation using cash flow and multiples approaches. Again, the reader will be able to replicate these methods as the book will provide practical cases for integrating ESG data in business valuation. Finally, for the readers that intend to go a bit further, they will learn about the academic research advances in ESG and business valuation.
Author(s): Dejan Glavas
Series: Sustainable Finance
Publisher: Springer
Year: 2023
Language: English
Pages: 227
City: Cham
Preface
Acknowledgments
Contents
Abbreviations and Acronyms
Value and Externalities in Economics and Finance
1 Value Theories in Economics
1.1 Definitions of Value in Economics
1.2 Intrinsic Theory of Value
1.3 Labor Theory of Value
1.4 Subjective Theory of Value
1.5 Monetary Theory of Value
2 What Are Externalities, and Why Should We Factor in Environmental, Social, and Governance Factors in Valuation?
2.1 Market Equilibrium
2.2 What Are Externalities?
2.3 Climate Change as an Example of Externality
2.4 Solutions to the Externalities Issue
2.4.1 Carbon Taxes
2.4.2 Regulations
2.4.3 Carbon Markets
3 Conclusion
References
Reminder on Common Valuation Techniques
1 Introduction and Purpose
2 Define the Value of a Stock or an Asset
2.1 Introduction to the Value of an Asset
2.2 Sharing Value Between the Stakeholders: Enterprise and Equity Value
2.3 Direct and Indirect Valuation Approach
3 Generating Value and Cash Flows
3.1 Accounting for Valuation
3.2 Capital Employed and Financial Resources
3.3 Creating Value: Return on Investment and Return on Equity
3.4 Generating Cash Flows
4 The Cost of Capital
4.1 Understanding the Cost of Capital
4.2 The Perspective of the Investor
4.3 The Perspective of the Company
4.4 Matching Both Perceptions
4.5 Measuring Risk and Portfolio Theory
4.6 Introduction to the Capital Asset Pricing Model
4.7 Computing the Cost of Capital
4.7.1 Cost of Equity
4.7.1.1 The Risk-Free Rate
4.7.1.2 Equity Risk Premium (ERP)
4.7.1.3 A Brief Remark on Inflation
4.7.1.4 Beta
4.7.2 Cost of Debt
4.7.3 Weighted Average Cost of Capital
5 DCF Valuation
5.1 Estimating Cash Flows in the First Phase (the Business Plan)
5.2 Terminal Value
6 Relative Valuation (Multiples)
6.1 Choosing a Relevant Variable
6.2 Indirect and Direct Relative Valuation Approach
6.3 Relevant Observation Period
6.4 Peer Group
6.5 Application
6.6 Going Further with Multiples
6.6.1 EBITDA Adjustments
6.6.2 Net Debt Adjustments
7 Conclusion
References
ESG Data and Scores
1 Definition and Use Cases
1.1 An Aggregation of ESG Indicators
1.2 A Wide Diversity of Rating Methodologies
1.2.1 Risk-Based Approaches
1.2.1.1 Target and Context
1.2.1.2 Interconnectivity of ESG Risks
1.2.1.3 Assessment of ESG Risks
1.2.1.4 Reputational Risks
1.2.2 Impact-Based Approaches
1.2.2.1 Motivations for Seeking Impact
1.2.2.2 Impact Is Still Difficult to Define
1.2.2.3 Positioning Impact Initiatives
1.2.2.4 Choosing the Right Impact Strategy
1.2.2.5 Implementing Impact Strategies
2 The ESG Rating Landscape
2.1 Data Providers and Rating Agencies
2.2 Main Corporate Reporting Standards
2.2.1 Global Reporting Initiative
2.2.2 Sustainability Accounting Standard Board
2.2.3 Task Force on Climate-Related Financial Disclosure
2.2.4 CDP
2.3 Fintech and Innovation
2.3.1 Artificial Intelligence and Machine Learning
2.3.2 Computer Vision and Satellite Imagery
2.3.3 Blockchain and Distributed Ledger Technology (DLT)
3 Legal Framework
3.1 The EU Framework
3.1.1 A Comprehensive Framework
3.1.2 The European Taxonomy
3.1.2.1 What Is the Taxonomy?
3.1.2.2 How Does It Work?
3.1.2.3 How to Apply It?
3.1.3 SFDR, CSRD, and Benchmarks
3.1.3.1 Sustainable Finance Disclosure Regulation
3.1.3.2 Corporate Sustainability Reporting Directive
3.1.3.3 Climate Benchmarks
3.2 The US Framework: SEC Rules and ISSB
4 Conclusion and Limitations
4.1 Data Issues
4.1.1 Low Data Quality
4.1.2 Data Reporting Challenges
4.2 Divergence in ESG Ratings
4.2.1 Sources of Divergence
4.2.2 How Does Divergence Affect the Use of ESG Ratings?
4.2.3 Divergence Is a Way to Stand Out
References
Cash Flow Valuation and ESG
1 Reminders
2 DCF and the Many Challenges Raised by ESG
2.1 The Recency of ESG
2.2 A Wide Variety of Uncertainties Associated with ESG Stakes
2.3 Impact of ESG on DCF
2.3.1 Forecasts and ESG
2.3.1.1 Revenues and Market Addressed
2.3.1.2 Revenues and Market Shares
2.3.1.3 Cost of Production
2.3.1.4 Production Tools, Investments, and Technology
2.3.1.5 Regulations and Industry
2.3.2 Long-Term Growth Rate and ESG
2.3.3 Cost of Capital and ESG
2.3.3.1 Cost of Capital Components
2.3.3.2 Practicalities in the Assessment of the Beta Factor
2.3.3.3 Beta Factor and ESG
2.3.3.4 Differentiation Between Companies from the Same Industry
3 ESG Within the Forecasts and Sensitivities on the Value
3.1 DCF Sensitivity on ESG-Adjusted Forecasts
3.1.1 Objective of the Simplified Model
3.1.2 Simplified DCF Model, Part I: A Unique Investment
3.1.3 Simplified DCF Model, Part II: Periodically Renewed Investments
3.1.4 Sensitivity of ESG-Related Parameters on DCF, Based on the Simplified Models
3.1.4.1 First Example, the Power of ESG Dynamics on DCF
3.1.4.2 Real Options
3.1.4.3 Irreversibility of the Investment
3.1.4.4 The Pressure of Stakeholders for ESG Improvements
3.1.4.5 Incentives for ESG Improvements with Stronger Dynamics than the Discount Rate
3.1.4.6 NPV Are Sensitive to ESG Projects
3.2 Terminal Value and Normative Cash Flows
3.2.1 Truncation and Extension of Cash Flows Series
3.2.2 Projects that Are Planned Beyond the Horizon of the Business Plan
3.2.3 Scenarios of Cash Flows
References
Cash Flow Valuation and ESG: Case Study
1 An Example of ESG Integration
2 Gathering Data
2.1 Internal Data
2.1.1 Quantitative Data
2.1.2 Qualitative Data
2.2 External Data
2.2.1 ESG Data Providers
2.2.2 Sell-Side Research
2.3 Company Data
2.3.1 Company Reports
2.3.2 Company Meetings
2.4 Controversies
3 Setting Out the Framework
3.1 Which Framework to Choose?
3.1.1 Absolute View
3.1.2 Relative View
3.2 ESG Momentum
4 Assessing Materiality
4.1 Is the Data Material?
4.2 Document
4.3 Other Considerations
5 Implementation in the DCF Model
5.1 What Line Should Be Amended?
5.1.1 Growth
5.1.2 Costs
5.1.3 Liabilities
5.1.4 Weighted Average Cost of Capital
5.2 Is the Impact Quantifiable?
5.2.1 Yes (a Quantifiable Impact)
5.2.2 No (an Unquantifiable Impact)
5.3 The Specific Case of WACC
5.4 Document Final Impact on Target Price
6 Practical Examples
6.1 Template
6.2 Positive Case: Renewable Utility
6.2.1 Data Gathering
6.2.2 Framework
6.2.3 Materiality
6.2.4 Valuation
6.2.5 Conclusion
6.3 Negative Case: Basic Material Company
6.3.1 Data Gathering
6.3.2 Framework
6.3.3 Materiality
6.3.4 Valuation
Reference
Multiple Valuation and ESG
1 Reasons to Adjust Valuation Multiples
2 Simple Multiple Adjustment
2.1 Conceptual Framework
2.2 Adjustment Method
2.3 Example
3 Statistics-Based Multiple Valuation Adjustment
3.1 Fundamental Value Drivers
3.2 Multiple Regression Analysis
3.3 Ordinary Least Squares Estimation
3.4 Model Assumptions Testing
3.4.1 Linearity
3.4.2 Multicollinearity
3.4.3 Homoscedasticity
3.4.4 Normality
3.5 Evaluating the Model Quality
3.5.1 T-Test and P-Value
3.5.2 F-Test
3.5.3 Goodness-of-Fit Test
3.5.3.1 R-Squared and Adjusted R-Squared
3.5.3.2 Akaike´s Information Criteria and Bayesian Information Criteria
3.5.4 Using the Model to Estimate Enterprise Value or Equity Value
3.5.5 Using the Empirical Model of Damodaran (2023)
3.5.5.1 Regression
3.5.6 Testing Linearity, Multicollinearity, Homoscedasticity, and Normality
3.5.6.1 Linearity
3.5.6.2 Multicollinearity
3.5.6.3 Homoscedasticity
3.5.6.4 Normality
3.5.6.5 Updated Model
3.5.7 Goodness-of-Fit Measures
3.5.7.1 An Example of Firm Multiple Computation
4 Conclusion
5 R Code to Perform Tasks Provided in this Chapter
5.1 Regression Analysis
5.2 Predicted Vs Residuals Plot
5.3 Pearson´s Correlation Matrix
5.4 Variance Inflation Factor
5.5 Breusch-Pagan Test
5.6 Normality: Quantile-Quantile Plot Variable Beta
5.7 Normality: Jarque-Bera Test
5.8 Akaike Information Criterion and Bayesian Information Criterion Calculation
References
Research Advances in Valuation and ESG
1 Theoretical Frameworks
1.1 Market Equilibria Between Green and Nongreen Investors (Heinkel et al., 2001)
1.1.1 Overview
1.1.2 Equilibrium Between Green and Neutral Investors and Cost of Capital
1.1.3 Equilibrium Model
1.1.4 Empirical Evidence
1.1.5 Contributions and Implications
1.2 Nonpecuniary Utility (Baker et al., 2018)
1.2.1 Overview
1.2.2 Framework to Price Green Bonds
1.2.3 Prediction to Test Pricing Patterns of Green Bonds
1.2.4 The Role of Certification
1.2.5 Framework to Examine Ownership Concentration of Green Bonds
1.2.6 Prediction to Test Ownership Concentration of Green Bonds
1.2.7 Contributions and Implications
2 Empirical Evidence of the Link Between ESG, Cost of Capital, and Firm Valuation
2.1 Environmental Profile´s Impact on the Cost of Capital (Chava, 2014)
2.1.1 Overview
2.1.2 Environmental Profile
2.1.3 Estimating Cost of Equity and Cost of Debt Capital
2.1.4 The Link Between Environmental Profile and Cost of Equity and Cost of Debt Capital
2.1.5 Contributions and Implications
2.2 Corporate Environmental Responsibility´s Impact on the Cost of Equity (El Ghoul et al., 2018)
2.2.1 Overview
2.2.2 The Link Between CER and Equity Pricing
2.2.3 Estimating Cost of Equity and Environmental Costs
2.2.4 Results
2.2.5 Contributions and Implications
3 New Asset Pricing Models
3.1 The ESG-Efficient Frontier (Pedersen et al., 2021)
3.1.1 Overview
3.1.2 Portfolio Choice Depending on ESG Appetency
3.1.3 ESG-Adjusted CAPM
3.1.4 Contributions and Implications
3.2 Sustainable Capital Asset Pricing Model (Zerbib, 2022)
3.2.1 Introduction to S-CAPM
3.2.2 S-CAPM for Investable Assets
3.2.3 S-CAPM for Excluded Assets
3.2.4 Empirical Analysis
3.2.4.1 Proxy for the Cost of Externalities
3.2.4.2 Proxy for the Proportion of Green Integrators´ Wealth
3.2.5 Empirical Results
3.3 Conclusion on New Asset Pricing Models Articles
4 Market Reactions Facing Green Sentiments
4.1 Green Sentiment in Financial Markets (Bessec & Fouquau, 2020)
4.1.1 Methodology and Environmental Media Indices
4.1.2 Fama-French Model (Fama Fama & French, 2015)
4.1.3 Empirical Analysis: Green Sentiment Matters
4.2 Green Sentiment, Stock Returns, and Corporate Behavior (Brière & Ramelli, 2021)
4.2.1 Overview
4.2.2 Green Sentiment Index: Arbitrage Activities of ETF
4.2.3 Effects of Green Sentiment on Stock Returns
4.2.4 Effects of Green Sentiment on Corporate Behavior
5 Conclusion
References
