How companies show up in the capital markets with clear, credible reporting, will impact in predictable ways their near and long term value creation.
- Wes Bricker, Vice Chair—US and Mexico, Assurance Leader, PwC
Should management teams and boards maximize shareholder value or seek to drive value for all stakeholders? In other words, should they embrace shareholder primacy or stakeholder capitalism? There are credible views on both sides of this debate, but it was clear at the recent World Economic Forum in Davos that executives are poised to focus on stakeholders in 2020 and beyond.
It is also clear that those executives will have to win over vocal skeptics, including many in the investor community, on whether these stakeholder activities create value for companies. We believe they do. Strategies such as environmental, social, and governance (ESG), for example, how a company helps conserve the natural world (the "E"), builds relationships with its people and communities (the "S"), or governs in a responsible way (the "G"), create value—intrinsic value— through an emphasis on stakeholder interests. And, if companies are transparent to shareholders about efforts to address stakeholder priorities, market value will likely increase over time as well.
So what is intrinsic value anyway?
Intrinsic value is a forward-looking measure of the worth of a business based on a company's strategies and its ability to execute them.
Security Analysis, Benjamin Graham and David Dodd, Columbia Business School, 1934
Skeptics also say that socially-responsible strategies are great in principle, but often look less rewarding in terms of return on investment. However, we believe that is mostly a function of capital allocation frameworks that fail to properly quantify the value of both tangible and intangible attributes. Although this limitation can lead to suboptimal go/no-go decisions for any investment, it disproportionately impacts investments with multiple attributes and significant intangible benefits that must be quantified to accurately measure potential returns. Multiple attributes, such as delivering discrete cash flows while also enhancing the value of an unrelated asset, are common in various kinds of projects, including many that have an ESG element.
At the same time, it's not enough to just develop a purpose-led strategy and to implement a capital allocation framework to assess each investment's relative contribution to intrinsic value. For this to have the desired impact on market value, the ultimate source of shareholder return, management also needs to effectively communicate this information. Making this information available would also facilitate the construction of indices to enable the investment community to identify companies that embrace a strategy of creating shareholder value through a focus on stakeholders.
...integrating ESG factors allows for greater insight into intangible factors such as culture, operational excellence and risk that can improve investment outcomes.
- Goldman Sachs research report, April 2018 (quoted in petition sent to Brent J. Fields, secretary of the SEC, by Cynthia A. Williams and Jill E. Fisch, University of Pennsylvania)
Enhancing intrinsic value
Management can enhance intrinsic value by increasing future cash flows, reducing risk, or a combination of the two. ESG strategies can be a significant source of both.
Increasing cash flows
ESG strategies can lead to increases in the value of a company's intangibles and competitive advantage. Actions that amplify a firm's competitive advantage typically increase future cash flows from top line growth (e.g., consumer products that appeal on the basis of ESG factors) or lower costs (e.g., more efficiency from ESG). Increases in cash flows may also come from increases in the value of intangibles the company controls, such as brands or workforce assets.
For example, a socially-conscious company can make its supply chain more environmentally friendly. Doing so could enable premium pricing with its existing customers, increase the stickiness of those customers, or even attract new customers. Or, a company focused on environmental factors in its supply chain could strengthen its resilience to energy and climate transitions, thereby reducing the cost of potential disruption in the long term. All of these effects could contribute to higher cash flows and a more valuable brand. Early studies into these efforts support this. NYU Stern's Center for Sustainable Business found that 50% of consumer products growth from 2013 to 2018 came from sustainability-marketed products.
Another management team may enhance its company's brand by focusing on diversity and inclusion, which could increase the company's relevance to a new group of customers. This type of focus could also lead to higher levels of engagement and loyalty from employees. More engaged employees stay longer and create a stronger culture, both of which yield tangible and intangible benefits that drive cash flow and intrinsic value.
Since these types of intangibles are often not recorded in the financial statements, or, if recorded, are not adjusted to reflect increases in value, management will need to identify ways to communicate this value creation to its shareholders.
Reducing risk and lowering the cost of capital
The other key input into the valuation of a company is the cost of capital. The cost of capital is based on the riskiness of a company's cash flows, especially as a function of market-based macroeconomic events. Management can reduce risk, and, consequently, a company's cost of capital, by employing strategies that focus on its broader responsibility to all stakeholders. For example, a number of large asset managers have stated that they are now considering climate change risks directly in valuations of companies rather than simply as tail risks. Although these potential impacts lie in the future, their view is that they now have a high-enough probability that they should impact value today. Accordingly, a company that invests in ESG strategies to mitigate the future impact of climate change on its operations would expect to observe a reduction in its cost of capital relative to peers that make no such investments. In line with this perspective is the fact that a company that is transparent regarding its ESG strategies has lower volatility because it is less likely to be negatively impacted by tail risks, such as fines imposed by regulators.
ESG strategies can reduce risk, and communication of those strategies to the markets can further reduce risk because transparency helps the investment community understand the risks the company is addressing and the drivers of intrinsic value it is focusing on.
ESG strategies can drive significant stakeholder and, in turn, shareholder value for organizations, but management teams must evolve their investment decision making process by rigorously quantifying the qualitative benefits of these efforts.
- Aaron Gilcreast, US Valuation Leader, PwC
Prioritizing purpose-led initiatives
We have written before about the importance of becoming a purpose-led organization, in part by embedding ESG strategy within core strategy. The translation of any strategy into execution passes through a capital allocation framework. As such, a second step on the journey to becoming a successful purpose-led organization is evolving your capital allocation framework to properly capture the value of both tangible and intangible attributes. For example, a company may have multiple opportunities for change—such as reducing air pollution or improving labor practices at subcontractors—but only enough resources to focus on one area at a time. This is one critical path of reconciliation between stakeholder and shareholder objectives. A smarter allocation framework will allow management to prioritize and invest in stakeholder initiatives that drive maximum intrinsic value over the long term.
So how should companies best allocate their people and capital to these strategies to drive maximum returns? Robust valuation methodologies can help companies assess the utility of multiattribute initiatives that have both direct and indirect, or tangible and intangible, value impacts, such as more direct sales and improved corporate brand. The key is to quantify the value of each initiative by considering the trade-offs in selecting one initiative instead of another. A systematic valuation approach can be a means to reassure shareholders that initiatives make sense not only from a stakeholder perspective, but from the perspective of intrinsic value creation.
Giving investors decision-useful purpose-led information
With the rise of passive investing, investors increasingly rely on third-party ESG ratings or indices (rather than company ESG disclosures) as a component of their investment decisions.
While designed to "grade" companies' purpose-led and ESG strategies, these indices may not be effective because of challenges index providers and ESG rating companies face in developing their ratings. Their assessment of ESG activities is constrained by the quality of the companies' ESG disclosures, which are largely voluntary, not standardized, and rarely audited. ESG rating companies are then left to uncover other information that either supports a company's rating or goes against it. Finally, the fact that many ESG indices include hundreds of companies has left some investors questioning whether the criteria used in construction were substantive.
As a result of these challenges, index providers have to use their own discretion when assessing ESG initiatives, which introduces subjectivity as they convert largely qualitative disclosures into quantitative assessments. This likely results in inconsistencies across index providers. These complexities make it more difficult for investors to determine if a particular ESG index suits their investment needs.
Regulators have this issue in their sights. SEC Chair Jay Clayton recently discussed the use of ESG data in investment decisions and noted that not all companies in the same sector use the same standards to manage and report their efforts. He also noted that investor analysis and the investor approach to each area of ESG vary widely, and questioned whether investors have the information they need.
Do retail investors and those who advise them understand how indices are constructed from (1) a technical perspective (e.g., weightings, adjustments and the like), (2) from a market exposure perspective (e.g., opportunities and risks the index incorporates), and (3) as a subset of those opportunities and risks, any key value judgments the index provider has made (e.g., to include or exclude certain types of companies)? What can we do to ensure that investors understand these topics? Should we encourage or require more disclosure?
-SEC Chair Jay Clayton, November 2019
Chair Clayton confirmed the SEC's focus on this area in his remarks accompanying the SEC's recent proposal to modernize and enhance financial disclosures.
… our staff in the Office of Compliance Inspections and Examinations is reviewing disclosures of investment advisers and other issuers regarding funds and other products that pursue environmental or climate-related investment mandates to ensure that investors are receiving accurate and adequate information about the material aspects of those strategies.
-SEC Chair Jay Clayton, January 2020
To remain invested in companies 'without understanding how they are positioned in climate transition poses a real risk.
- Adam Matthews, Church of England pension fund's director of ethics and engagement (as quoted in the New York Times, Church of England Devises an Index for Climate-Conscious Investing, January 31, 2020)
What is being done?
Some are taking matters into their own hands. The New York Times reports that the Church of England has established a new index "that rewards companies working to curb their carbon-dioxide emissions in line with the targets of the 2015 Paris agreement, and bars companies that are perceived as environmental laggards." The Church will put more of its £600 million of pension money to those companies that perform well based on the index.
What can be done?
Index providers can provide more disclosures on the specific ESG exposure that an index seeks to capture, and what discretion they used in the index construction, so investors have better information. Index providers and ESG rating companies can also increase transparency on the details of each index and how they select companies for inclusion to improve investor understanding of and confidence in such measures.
Management should perform an analysis to determine which ESG strategies are material, report on them using high-quality standards and policies, and include explanation of the value they create. Using high-quality generally accepted ESG reporting standards and frameworks would aid comparability, and independent assurance would aid reliability. Both steps would give investors more confidence as to the quality of the information.