ESG, the valuations process and value creation

Encouragingly, the same report points to increasing evidence of climate action in the form of policies, regulations and market instruments. As this trend grows and becomes embedded at the corporate level, it will become increasingly important for companies to be able to quantify the impact of ESG-aligned activities and outputs on the value of their business.

Understanding the relationship between ESG and value

To successfully invest for the future, companies must fully understand the impact of ESG on the value of their business. With quantitative data, decision-makers can accelerate change and prioritise investment in the knowledge that they are creating sustainable value. While traditional valuation approaches remain valid, they must be robustly applied to understand how a company is perceived by its employees, regulators, customers and investors—and the potential consequences on cash flow.

This activity will become increasingly important in the future—not only because of the intense focus on ESG criteria, but also due to companies’ deals strategies. Our recent CEO Survey found that 38% of Irish CEOs will pursue new M&A activity in 2022, for example. Meanwhile, 9% plan to sell their business and 53% said that they would enter a new market in the year ahead.

This follows a record-beating year for deal values, which exceeded $5tn for the first time in 2021. While we don’t expect 2022 to exceed last year’s levels, the indications are that it will be another strong year for M&A activity.

In that context, how can companies build ESG into the valuation process and ensure that nothing is left on the table?

Bridging the information gap

From changing consumer behaviours to the transition to net zero, several factors are driving the increased focus on ESG and positioning it at the top of the CEO’s strategic agenda. While our clients know that action is important, they lack the information necessary to make informed decisions that lead to progress.

This is a common challenge, as the quality of information available to measure both a company’s ESG performance and its impact has simply not kept pace. It also varies considerably from sector to sector. For example, there are no universally accepted ESG ratings against which companies can be benchmarked, with information often volunteered as opposed to audited. And although our capacity to measure environmental factors is comparatively well-developed, the value impact of social and governance criteria is no less important.

The recommended valuation model

When it comes to the value impact of ESG, our clients’ approaches to valuation typically falls into three buckets:

1. A market-based approach (i.e. relying on a quoted company share price to illustrate the impact of ESG actions on value).
2. Subjective adjustments (i.e. tweaking the discount rate or terminal value assumptions in a discounted cash flow analysis).
3. Direct cash flow adjustments (i.e. identifying the ESG elements that are critical to the company’s success and financially modelling them).

A targeted version of direct cash flow adjustments is the recommended option, whereby a company explores the most material ESG demands of key stakeholders and assesses the cost of meeting or exceeding them—and the subsequent financial implications. For example, consider the following:

• Customers: identify the ESG issues that are most material to your customers and benchmark your performance against your competitors. Then, consider the price elasticity of different customers to estimate whether this will enhance or destroy brand value through changes in demand or discounted/premium pricing.
• Employees: again, identify the ESG issues that are most material to your employees and benchmark your performance against your competitors. Consider the extent to which this has a meaningful impact on employee retention and talent recruitment, as this will affect cash flow.
• Regulators and supply chain: compare forecast emissions with forecast energy prices, capturing expected changes in carbon taxes for example. While Scope 3 emissions may not be directly felt by the company, increases in taxes may travel through the supply chain to impact cash flow.
• Investors: given the significant demand from investors and lenders for ESG investment opportunities, there may be a ‘greenium’ to access capital if your company is perceived to have a sustainable objective. Understanding which ESG KPIs lenders are focusing on within your sector, and knowing your own performance in this context, could have a significant impact on your cost of debt and, therefore, value.

A compelling argument

Unless business leaders proactively identify the value impact of ESG, we risk depriving decision-makers of the very information they need to prioritise investment, accelerate change and deliver truly sustainable value.

The three actions businesses can take to prioritise value creation

A recent PwC report, ‘Creating value beyond the deal’, shows that just 61% of acquiring companies believe that their latest acquisition created value and only one in five said it created significant value.

Companies clearly need a strategic approach to ensure that every opportunity to create value throughout a deal is optimised. Whether you are seeking to cut costs, maximise the potential of your people, reinvent your business model or break into new value markets, you must prioritise value creation.

To do that, you must:

1. Demonstrate your ESG and resilience credentials: shareholder returns are no longer the sole focus of a company’s value. The focus is increasingly turning to measures around society (purpose, ESG) and business resilience. A resilient organisation that can respond quickly to shocks and opportunities and include its broader societal impact in its decision-making represents the new gold standard.
2. Move from tactical to strategic:  a tactical response will only get you so far in a challenging market environment. It may be necessary in the short-term, but current conditions warrant a longer-term perspective.
3. Make it work for you: with so many variables, it’s important to tailor the value creation approach to each business and its circumstances. This requires a creative, collaborative approach to finding the right answer.

We are here to help you

Amid continuing disruption, more companies are asking what they can do to improve the value of their business as a whole, and incorporate ESG criteria into the valuation process. With our expert teams and global network, we can help you on that journey. Contact us today.