The Impact of Environmental, Social and Governance Factors on Business Valuation

Environmental, social and governance (“ESG”) factors have become increasingly important to corporations and their investors.

The International Valuation Standards Council (“IVSC”) released a report earlier this year on ESG factors and their impact on business valuation.¹  Part of the report focuses on a study performed by Morningstar that indicated that open-end and exchange-traded funds investing in ESG-minded companies have often outperformed otherwise similar funds without an ESG focus. Specifically, 59% of sustainable funds that have survived over the last 10 years have outperformed the average surviving traditional fund with otherwise similar investment criteria. In addition, 72% of sustainable funds were still available to investors 10 years later, compared with only 46% of traditional funds. 

The report shows that sustainable funds often delivered higher returns during the economic downturn created by COVID-19 in the first quarter of 2020. The following factors were noted as likely causes for these higher returns exhibited by the sustainable funds:

• ESG-focused companies tend to enjoy more conservative balance sheets and competitive advantages, which allow them to be more resilient during market downturns. 

• Companies that score high on ESG also tend to be well-run businesses that treat all their stakeholders fairly, address their environmental challenges, and have lower levels of controversies. 

COVID-19 has forced most management teams to evolve each day to improve their governance structures. COVID-19, coupled with increased environmental disasters and widespread social unrest, caused 2020 to be a natural time for many companies to adopt ESG frameworks. Even in 2019, 9 out of 10 companies on the S&P 500 produced sustainability reports. 

Although most organizations agree on the importance of ESG factors on value creation, succinct guidance, metrics and standards on the topic are lacking. To address this need, the IFRS Foundation has begun to seek input on the need for international ESG standards. Other organizations, including the CFA Institute and the European Financial Reporting Advisory Group (“EFRAG”), have also started to develop ESG standards.

Some stakeholders argue that ESG disclosures are nonfinancial in nature and would not impact the financial statements. However, increasing numbers of investors are asking questions like the following to assess the long-term viability of a potential investment:

• Would the business be impacted by climate change and regulation?

• Are the business’s social practices and policies conducive to attracting and retaining quality customers and employees?

• Is the business’s governance environment able to handle future challenges?

The IVSC report shows that ESG factors impact all stakeholders of any business. Studies show that implementing an effective ESG framework may also result in increased business value because ESG considerations contribute to sustainable financial performance and the mitigation of future risks.   Schneider Downs has significant experience consulting with clients to increase the value of their business and preparing business valuations for a wide range of purposes.  For more information about Schneider Downs’ business valuation and other business advisory services, please contact Joel Rosenthal at 412.697.5387 or [email protected] or Steve Thimons at 412.697.5281 or [email protected].

¹ https://www.morningstar.com/content/dam/marketing/emea/shared/guides/ESG_Fund_Performance_2020.pdf