【TEJ Finance Research Institute】 A New Way of Incorporating ESG Factors into Business Valuation


You can use different methods to measure the impact of ESG, but is the effect objectively measurable?

Incorporating ESG into Valuation
ESG Investing has become popular in recent years. Source: Freepik


In 2014, the CFA Institute discussed incorporating ESG (Environmental, Social, and Governance) factors into business valuation. However, the practical implementation of ESG assessment is still under development.

Although many companies provide CSR or ESG-related ratings, the measurement involved in each rating varies greatly, thus confusing users. Given this, TEJ released the “TESG Rating Index (TESG Rating) ” on March 31, 2022, an ESG reference for investment and credit. In addition, we also use the TESG Rating to explore its correlation with commonly-used valuation multipliers, such as the price-to-book (P/B) ratio and price-to-earnings (P/E) ratio.

This article describes the correlation between ESG and corporate value and introduces how ESG factors are currently incorporated into valuation practices. We also explain the empirical analysis model and its results. Finally, we suggest directions for upcoming research.

Keywords: ESG, business valuation, SASB


📍How ESG can enhance corporate value
📍Incorporating ESG factors into corporate evaluation
📍Empirical analysis of the model
📍Conclusion and recommendations

How ESG can enhance corporate value:

Good ESG practices have become increasingly crucial for companies looking to improve their financial performance, corporate reputation, and long-term sustainability. The five advantages of good ESG practices are:

  1. Reduction in operating costs
  2. Policy support and subsidies
  3. Revenue growth
  4. Employees’ quality
  5. Sustainable competitiveness

Generally, pieces of literature support that companies with good ESG ratings have lower risks and may obtain more favorable financing rates, reducing the overall cost of capital.

Nevertheless, previous literature suggests an excessive emphasis on ESG may lead to decisions that harm corporate value. Taking “Diversity” as an example, if diversity is defined as “the company needing to recruit employees with specific personal characteristics to meet a certain percentage,” management may give up promoting the best employees to achieve that percentage, thus harming corporate value.

The traditional valuation method seldom considers the risks caused by ESG practices.

Incorporating ESG factors in business valuation

Before explaining our research, let’s first understand 3 practical approaches to incorporating ESG factors in business valuation.

(1) Market approach
The market approach adjusts companies’ valuation based on their ESG practices using publicly available information or ESG ratings from institutions. However, this method is subjective in determining the adjustment. It may result in double-counting errors if the industry, such as the automotive, food, or chemical industry, already reflects the differences in ESG.

(2) Income Approach — Cost of Capital
The income approach- Cost of Capital can adjust the cost of equity and discount rate to reflect ESG risks, increasing the cost of equity and the WACC. However, this approach still suffers from subjective and double-counting shortcomings if the beta value already reflects the market’s thought on ESG risks.

(3) Income Approach — Cash Flows
The income approach’s- Cash Flows is the most recommended approach to measuring the ESG impact. Compared to adjusting the market multiplier and discount rate, losses incurred by the negative ESG effect on the company are easier to estimate. Regulators and appraisers can consider the differences between companies within the industry, evaluate the significance of each ESG aspect, and supplement it with scenario analysis to partially reduce subjective factors.

ESG Valuation: Example of adjusting free cash flow to reflect the ESG impact
Table 1. Example of adjusting free cash flow to reflect the ESG impact

As shown in Table 1, the management listed three significant ESG aspects that may affect the company’s cash flow: one S and two E. After considering the impact of ESG, the free cash flow is 220. Only the possibility of “purchasing energy-saving equipment in response to climate warming” is believed to be relatively high. If so, the free cash flow after considering ESG will increase to 590.

By a professional judgment, the probability that the free cash flow considering ESG is 220 is 20%, and the probability that FCF is 590 is 80%— the free cash flow’s weighted average is 516— as shown in Figure 2.

ESG Valuation: the scenario analysis
Figure 2. Results of scenario analysis

By adjusting the cash flow to the magnitude of each ESG aspect, the subjectivity is relatively low, and the reasonability of the predictability is increased.

Empirical analysis of the model

(1) Period and Company Coverage
This study uses the TESG Rating for empirical analysis consistent with the database. However, given the importance of the information disclosure variable added to the TESG Rating since 2019, the analysis period of this study is from 2019 to 2020. For the subject, companies listed on the stock market are included, while emerging market companies are excluded.

(2) Research Methodology
According to the SASB standards, each industry has unique ESG disclosure items; as a result, this study groups samples into 11 groups according to SASB’s primary industry categories.

Moreover, this study takes June 30 as the base date, collects the closing price of trading days after June 30 (the next day, week, month, and six months) and calculates the average P/B and P/E of companies at different TESG levels. In addition to TESG levels, this study explores whether the relative level implications and the raw quantitative scores impact the results.

We expect that good ESG will positively impact company value, so the market should give higher multipliers.

(3) Descriptive Statistical Results
The results show that regardless of periods, the level implications or the level of TESG, in the four SASB primary industries, a positive correlation between ESG quality and the average P/B multiplier can be observed. However, there are no significant differences in other SASB primary industry categories. Furthermore, The effect of the average P/E multiplier is weaker. A positive correlation between ESG quality and the average P/E multiplier can only be observed in the financial and transportation industry.

ESG valuation: the relationship between ESG and P/B ratio under SASB industry categories
Table 3. the average P/B ratios grouped by SASB primary industries and the level implication.
ESG valuation: the relationship between ESG and P/B ratio under TESG Rating level
Table 4. The average P/B ratios grouped by SASB primary industries and TESG levels

Table 4 shows that although the average P/B ratios don’t strictly decrease as ESG grades shift from A+ to C-, the groups with higher TESG levels generally have higher average P/B ratios. It becomes more apparent when grouping is based on the level implication, as shown in Table 3. Notably, the choice of stock price calculation doesn’t significantly impact the results, but further research may explore this in more depth.

(4) Regression Analysis
We also conducted regression analyses to directly investigate the relationship between TESG ratings and multipliers. First, four types of P/B multipliers over different periods were used as the dependent variable Y, while the Quantified levels (or Level implication, Raw scores) and changes in quantified levels were used as independent variable X. Regression analyses were separately conducted for four SASB industries: financials, food and beverage, consumer goods, and transportation (Table 5).

ESG Valuation: the regression analysis of ESG and P/B ratio
Table 5. the regression analysis results: the significance level (p-value) of the independent variable regression coefficient (P/B).

Take the transportation industry as an example, a regression analysis was conducted with the P/B ratio one month after the base date as the dependent variable Y and the quantified level and changes in the current period’s quantified level as independent variable X. The regression coefficient p-value for the quantified level was found to be < 0.1. When raw scores replaced the quantified level, the regression coefficient p-value for the raw scores was < 0.05.

In Table 5, all significant independent variables had positive regression coefficients. This suggests that as the TESG rating improves, the P/B ratio for companies in SASB primary industries also increases. This is consistent with the expectations of this study. Among these, the effects were most significant in the consumer goods and food and beverage industries, while those were not significant in certain conditions in the financial and transportation industries.

Continuing with the above model, this study replaces the independent variable with the P/E ratio and performs regressions separately for the financial and transportation SASB industries (Table 6).

ESG Valuation: the relationship between ESG score and P/E ratio
Table 6. the regression analysis results: the significance level (p-value) of the independent variable regression coefficient (P/E).

In Table 6, all significant independent variables have positive regression coefficients, suggesting a significant positive correlation between the independent variables and the P/E ratio. The results show that when using stock prices one day, one week, or one month after the base date, the higher the TESG rating of financial companies, the higher the P/E ratio. However, the effect is insignificant in the transportation industry.

Conclusion and Recommendations

While incorporating ESG factors in evaluating companies is widely accepted in the valuation field in Taiwan, actual cases of its application still need to be made available and comprehensive. If adjustments are necessary, adjusting cash flows in the income approach is recommended due to its analytical objectivity.

In addition, this study utilized TESG Rating for empirical research and found a significant positive correlation between the P/B ratio and ESG ratings for companies in the food and beverage, consumer goods, and transportation industries under SASB.

For the financial industry, the P/B and P/E ratios were significantly positively correlated with their ESG ratings. It is assumed that the financial and food industries are subject to regulatory oversight; they have had to prepare CSR reports since 2014. As a result, market investors pay relatively more attention to CSR issues, thus fueling stock prices.

Last but not least, this study provides an initial exploration of the relationship between ESG and valuation multipliers, but there is still room for improvement. For example, consider adding additional control variables (profitability, revenue growth rate, etc.) to the regression model and obtaining data for longer years. Moreover, this study found that the association between the P/B, P/E ratios, and TESG Rating was limited to specific industries; and the results for other valuation multipliers (EV/REV, EV/EBIT, EV/EBITA, etc.) remain to be revealed in future research.

TESG Sustainable Dataset offers all the necessary ESG information! Please refer to the link to see why ESG matters and what our dataset provides …

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TEJ 台灣經濟新報
TEJ Finance Research Institute

TEJ 為台灣本土第一大財經資訊公司,成立於 1990 年,提供金融市場基本分析所需資訊,以及信用風險、法遵科技、資產評價、量化分析及 ESG 等解決方案及顧問服務。鑒於財務金融領域日趨多元與複雜,TEJ 結合實務與學術界的精英人才,致力於開發機器學習、人工智慧 AI 及自然語言處理 NLP 等新技術,持續提供創新服務