Risk – Return – Impact – Value

For decades there has been a generally accepted business and investment orthodoxy that, in the words of the Business Round Table, “maximizing value for shareholders as the sole purpose of a corporation”. This view, popularised by Milton Friedman in the 1970’s posits that shareholders are concerned with making as much money as possible and are not concerned with broader societal issues beyond acting within the law and ethical norms. The idea that companies should seek to ‘do good’ for society was dismissed not just as inconsistent with maximising shareholder value but, in fact, incompatible with it.

It has dominated much of the way in which we view business and has had particular influence on the manner in which valuation professionals calculate value. We look at a projected income stream, we assess the risk of achieving this income and ascribe a value to this, assuming that an investor is not concerned with factors relating to the income that do not impact on risk. But is this assumption robust? Do investors really not care about the externalities of their investments if they do not impact on risk? Or do our altruistic inclinations in fact mean that, given the appropriate information, we place a value on these externalities and factor these into investment decisions? If this is the case, what are the implications for the approach we currently take to valuing companies and appraising investments?

Recent years has seen a shifting tide of popular belief from the shareholder centric view to a broader view that considers stakeholder interests. This trend has brought with it the emergence of ESG (Environmental Social and Governance) reporting which seeks to assess the company’s performance across a range of issues impacting on the environment and society in general.

While some may argue that ESG reporting is a distraction for management from the business of generating profit, a recent meta study published by NYU-Stern [1] found that just 8% of studies reviewed found a negative correlation between ESG and financial performance. It therefore seems safe to say that rather than interfering with the delivery of profits firms that focus on ESG can expect to perform as well or better than if they had they ignored this perspective. Added to this, there is evidence that companies who focus on ESG are capable of obtaining finance at lower rates than those that do not [2]. This makes intuitive sense; by focusing on ESG, firms are actively managing stakeholder risks that may have a negative impact on their business in the future and so the overall risk profile of the firm should be lower. So combining these two pieces of information, that company performance should be expected to be the same or better while at the same time driving down borrowing costs we can conclude that ESG in fact increases shareholder wealth by increasing the value of their investment.

True, you might say, but this isn’t actually reflective of any kind of altruistic intention on the part of an investor, it is simply a risk management strategy and so we simply need to consider it in the context of our overall risk analysis of an investment. Is it just an additional factor impacting on specific risk premium (alpha)? What if we switch our focus further from managing risk to actually measuring the impact of a company’s business on the environment and society in general? For example, if we take two similar companies offering an annual return to investors of €1m. Having analysed the various risk factors, let’s assume that we conclude that the WACC for both companies is 10% implying a valuation of €1m. Now let’s imagine that Company A, through its business, reduces the number of people who are homeless while Company B has a neutral impact. Armed with this additional information I personally am certainly more likely to invest in Company A, and I’m sure I’m not alone in this. In fact there are a number of emerging movements such as Pensions For Purpose, and Make My Money Matter, which seek to highlight that over the longer term in particular, investments that benefit society are ultimately beneficial for individual investors as they are a part of that society. So what are the implications for Company B? In order to make its return more attractive it may have to offer it at a lower price and therefore giving a better financial return to shareholders. It therefore appears reasonable to believe that if a company that focuses on affecting a clear and demonstrable positive impact on society this has the potential to enhance its value.

If we can accept the principle that an investor places value not just on the potential financial return of an investment but also the broader impact on society or the then the next logical question in the scenario above is; how much additional financial return must Company B provide in order to offset the societal good done by Company A. An additional €1 is unlikely to make much of an impact on an investment decision but what about an additional €100,000? What if instead of offering an additional financial return Company B was able to demonstrate that its business improved biodiversity in currently degraded forests. Putting personal preferences aside, how might an investor compare one benefit to another?

While we might view these benefits to society as unquantifiable ‘greater goods’, there has actually been considerable thought given to how we might measure these in monetary terms [3]. This involves estimating the Economic Value of the outcomes to society, adjusting for risk and then estimating a terminal value in a similar methodology to the way we would approach valuing an investment cash flow. The next step is to relate this value creation to the financial statements of the company through Impact Weighted Accounts, which seek to measure and report on a company’s financial, social and environmental performance [4].

This goes some way to putting a monetary value on social or environmental impact and creating a framework for comparison. However, a question still remains as to how much financial value an investor might forego in exchange for ‘impact value’. While some investors will have their own ideas and parameters that guide these decisions I believe we are some way off having an observable market effect of ‘impact value’ which we could factor into our valuation or investment appraisal calculations. However, as Impact Weighted Accounts move from the periphery to mainstream I believe that we will increasingly be able to observe and measure this effect and I predict that by the end of this decade consideration of the non-financial impact will be firmly embedded in how we assess the overall value of a company.