Panellists: Dejan Glavas, PhD, Director of the AI for Sustainability Institute at ESSCA School of Management; Mathieu Joubrel, Co-founder and Chief Technology Officer at Valuecometrics; Marjène Rabah, PhD, Affiliated Professor at HEC Montréal; and Walter Viguiliouk, Managing Director, Sustainable Investing, Private Markets at Manulife Investment Management.

A growing body of research points to the impact of sustainability factors on company valuation, emphasizing the importance of properly incorporating these factors to build more accurate and precise models. On February 27, 2024, CFA Society Toronto hosted “Investing in Tomorrow: How Sustainability Reshapes Equity Value Today,” a panel to help attendees better understand how sustainability impacts equity value, how sustainability factors can be incorporated into company valuation, and the challenges of this incorporation. While many interesting points were made during the panel, this article focuses on the topic of environmental, social, and governance (ESG) factor integration, a main discussion point for panellists Dejan Glavas and Mathieu Joubrel.

Glavas and co-authors George Andrew Karolyi and Franck Bancel surveyed over 300 practitioners on their ESG integration methods. They found that a lack of rigorous, publicly available methodologies was a major limitation for practitioners in integrating ESG in valuation. To fill this gap, Glavas, Joubrel, and others published the academic, peer-reviewed book, Valuation and Sustainability: A Guide to Include Environmental, Social, and Governance Data in Business Valuation, to walk readers step-by-step through two practical and rigorous ESG integration methodologies. The book includes everything practitioners need to follow these methodologies, including the R code for their regression analysis. The authors explain that their intent was not to reinvent the wheel, but to return to traditional valuation models, such as the multiples model and the discount cash flow (DCF) model.

Why should practitioners adjust cash flows instead of the discount rate?

The survey revealed that many practitioners accounted for ESG risks and opportunities by adjusting the company’s discount rate. Glavas and Joubrel mentioned that this could be seen as a fundamental mistake and point out that it is risky to start adding “fudge factors” in the weighted average cost of capital (WACC)—a risk explained in Brealey, Myers, Allen, and Edmans’s book, Principles of Corporate Finance. When one starts adding factors to the discount rate, there is a risk that what is built may no longer be methodologically sound or supported by financial theory.

Additionally, cash flows and WACC account for two different things. The function of the WACC is to factor in the time value of money and risk, which includes systemic risks. However, specific company risks should be accounted for in the cash flows. The ESG risks a company faces will materialize as a cash flow impact at a given point in time. For example, cash flows could be negatively impacted by floods impacting factory operations or droughts that increase logistics risks. Other examples include the impacts of upcoming regulations, adaptation of company strategies, and workforce resilience. In the process of valuing a company, practitioners should try to assess the impact of these risks on company cash flows, while keeping the discount rate the same.

When asked if there were any situations in which adjusting the discount rate could be a suitable method of incorporating ESG factors, Glavas and Joubrel insisted that the main method of properly accounting for these factors is by adjusting the cash flows, not the discount rate. However, adjusting the discount rate could be appropriate in some situations, including when there is a lack of available data and high uncertainty regarding ESG’s impact on valuation and when a beta can be computed that properly factors in ESG risks (a method discussed in their book).

Why do you think so many practitioners continue to adjust the discount rate?

Their simple answer is that it is easier than going deep into the cash flows. Given the lack of available ESG integration methodologies, many practitioners have had to formulate their own adjustment methods. For example, some created rules where they adjust the WACC based on a specific company’s ESG rating or ESG risks. In situations where practitioners follow a portfolio of thousands of stocks, they have seen some of them build rules that work across the portfolio, as it may not be possible to adjust each stock based on their cash flows.

When asked if there is a relatively easier way to incorporate ESG factors into cash flows, Glavas and Joubrel suggested that practitioners could employ a multiples-based approach, where the price-earnings-to-ESG ratio is used instead of the price-earnings-to-growth ratio. This result can then be used to adjust the DCF, and practitioners can follow the steps and template provided in Valuation and Sustainability. Another slightly more complex method is the use of regression analysis, where ESG factors are used instead of financial factors. Their book also walks readers through available research on the creation of a sustainable capital asset pricing model (S-CAPM), which could also be used in valuation models.

By integrating ESG factors into valuation models, practitioners can build better, more accurate models. While there are still challenges in their incorporation, academics such as Glavas and Joubrel, along with others, attempt to address the market’s clear need for practical and rigorous methodologies based on financial theory. A sincere thanks to all panellists for sharing their expertise and to Glavas and Joubrel for the additional follow-ups.