Module 7

Integration in valuation

The European
Federation of
Financial Analyst
Societies
Sophienstraße 44,
60487 Frankfurt am Main
[email protected]
www.effas.com
Learning objectives

The learning objectives are:

§ Learn how to integrate qualitative analysis of material ESG challenges into valuation models.
§ Understand how ESG information influences financial estimates.
§ Engage with the integration of ESG into valuation models for equities, fixed income and other asset classes.

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Agenda

7.1. Introduction: ESG and valuation models

7.2. ESG integration in valuation models
7.2.1. Equities
7.2.2. Fixed income
7.2.3. Infrastructure
7.2.1. Other asset classes

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ESG Integration in investment decisions
Step 1: Qualitative analysis Step 2: Quantitative analysis Step 3: Investment decision

§ Gathering of relevant § The analyses performed in

§ Assessment of the financial stage 1 and stage 2 will lead
information from multiple
impact of material to a decision:
sources (including but not
ESG factors on securities in § Buy (or increase
limited to company reports
their portfolio(s) and weighting),
and third-party investment
investment universe. § hold (or maintain
research).
§ Adjustment of financial weighting), or
§ Identification of material ESG
forecasts and/or valuation § sell (or decrease
factors affecting the
models appropriately. weighting).
company.

Module 6 Module 7 Module 9

Source: A practical guide to ESG Integration for equity investing. PRI (2016).

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Integrating environmental, social and corporate governance factors in your analysis and valuation should help you to take a
better decision by enlarging the relevant information basis and to find the best risk-adjusted investment decision

Step 1 Step 2 Step 3 Step 4

Assess the financial Investment

Quantify the
impact of material decision
Identify financial impacts in the
ESG factors across
and material ESG financial
the whole Higher conviction
issues forecasting and
fundamental and more
valuation exercise
analysis comprehensive
risk-return view

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§ One of the essential functions of financial markets is to price risk in order to support informed, efficient capital-allocation decisions.
§ Accurate and timely disclosure of current and past operating and financial results is fundamental to this function, but it is increasingly
important to understand the governance and risk management context in which financial results are achieved.
§ We have already had good examples of the repercussions that weak corporate governance and risk management practices can have on
asset values.
§ These events have resulted in increased demand for transparency from organizations on their governance structures, strategies, and
risk management practices.
§ Without the right information, investors and others may incorrectly price or value assets, leading to a misallocation of capital.

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What is meant by Valuation? What are we trying to do?

§ In finance, valuation is the process of determining the present value (PV) of an asset.
§ Valuations can be done on assets (e.g. stocks, etc.) or on liabilities (e.g. bonds issued by a company)
§ For the purpose of this course, valuation of financial assets is done generally using one or more of the following approaches:
§ Absolute valuation models
§ Relative valuation models

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Absolute and relative valuation models

Absolute valuation models Relative valuation models

§ A relative valuation model is a business valuation method that

An absolute value is a business valuation method that compares a company's value to that of its competitors or
uses discounted cash flow (DCF) analysis to determine a industry peers to assess the firm's financial worth.
company's financial worth. § Some of the most common and useful metrics to utilize in
relative valuation include:
§ price to earnings ratio
§ return on equity
§ yield spread to a benchmark
§ enterprise value
§ price to free cash flow

Source: Investopedia.

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Examples of valuation models

Contingent claim
Discounted Cash Flow Relative valuation Liquidation
valuation

Discounted Present Value Excess return Real Intan- Asset class

CF models Stock-specific
Dividend Methods models options gibles specific

Standard Hybrid Mainstream Academic

models models valuation (factor) models

Intrinsic P/E , P/EG, DY,

FCFF Dividend Net Present CFROI / CROCI SML / CAPM Equity Risk
Value (IV) P/B,…
Discount Value (NPV) Premium
Monte EV/EBITDA, Fama-French 3-
FCFE Gordon Economic Value
Carlo FCF EV/EBIT... factor
Growth Adjusted Added (EVA) FED Model
Model Present Value Carhart
(APV) P/CF, P/FCF…
4-factor
Multi Stage
RoA, RoE, OPM,
DDM
…

P/S, …

Source: Friede, compare Damodaran (2005,2006, 2009) and Viebig, Varmaz and Poddig (2008).

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Process of fundamental analysis

Step 5: Investment decision

§ Investment Professional
Step 4: Convert Forecasts into a Valuation
§ Compare Value with PRICE to BUY, SELL,
or HOLD

Step 3 - Forecasting Payoffs

§ Measuring Value Creation
§ Forecasting growth
Step 1: Knowing the Business
§ The Products Step 2 - Analyzing Information
§ Business Model Strategy § In Financial Statements
§ Competitive Position
§ Outside of Financial
§ The Regulatory Constraints Statements

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The articulation of the financial statement

Beginning stocks Flows Ending stocks

Cash Flow Statement
Cash from operations
Beginning Balance Sheet Cash from investing Ending Balance Sheet
Cash from financing
Net change in cash
Cash Cash

Other Assets + Statement of Shareholders’ Equity + Other Assets

Total Assets Investment and disinvestment by owners Total Assets

- Liabilities Net income and other comprehensive
- Liabilities
income
Net change in owners’ equity Owners’ equity
Owners’ equity

Income Statement
Revenues
Expenses
Net income

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Corporate information beyond financials?

External Internal

§ Competition (market barriers, market § Business model (ROE, growth,

share) sustainable growth)
§ Industry environment (Potential in § Financial Strength (capital structure,
growth rates, regulatory framework) financial slack, FCF)
§ Management Qualityà Impact by
CEOs & CFOs

Insights from ESG Factors

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Corporate Governance:

Corporate Governance & Is the company understanding and managing well the risks and
management track record & opportunities - including the environmental and social risks - that
strategy it faces?
Industry and competitive analysis:
Which ESG trends and developments are changing the
competitive landscape to such an extent that it produces relevant
Industry and competitive Consistency with the changes in businesses within the sector?
analysis business model
Sustainability of business model:
Can the company adapt or is there the risk of becoming an
unsustainable business model?

Financial
strength

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Corporate
Governance &
management track
record & strategy
Industry and Consistency with
competitive the business
analysis model

Financial
strength

Company‘s financial statements

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The role of cash generation and risk pricing

In our fundamental analysis, we are going to focus on analysing and measuring the following two topics:

1. Ability of an investment to generate cash

2. Ability of an investment to create value with a manageable risk profile

Ø Therefore, FCF and the price of risk are always going to be at the core of the exercise in any asset class.
Ø Depending on the asset class and type of strategy, we will be putting more focus on one or the other.

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7.2. ESG integration in valuation models

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7.2.1. Equities

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ESG integration in future estimates

Beginning stocks Flows Ending stocks

Cash Flow Statement
Cash from operations
Beginning Balance Sheet Cash from investing Ending Balance Sheet
Cash from financing
Net change in cash
Cash Cash

Other Assets + Statement of Shareholders’ Equity + Other Assets

Total Assets Investment and disinvestment by owners Total Assets

- Liabilities Net income and other comprehensive
- Liabilities
income
Net change in owners’ equity Owners’ equity
Owners’ equity

Income Statement
Revenues
Expenses
Net income

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From financial estimates to valuation model

Financial
CAPEX Costs Sales ....
estimates:

Cash Cash Cash Cash

Flow Flow Flow Terminal
Flow ...
value
Year 1 Year 2 Year 3 Year 4

Company value

Discount Rate

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Examples of affected variables in the financial statements

Profit & Loss Account Cash flow statement Balance Sheet

Capex
Market share, volumes sold,
(allocation, timing, information Value of the liabilities and value
realized prices , Innovation of
on growth assumptions and of the assets
products, cost of debt, etc.
expected returns)

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ESG information affecting financial estimates: Financial vs. social/environmental impact

Financial impact:
§ Investment in more efficient plants:
Ø Lower costs due to more efficient use
of resources.

Social/Environmental impact:
§ Investment in more efficient plants:
Ø Positive impact on environment due to
less emissions.

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ESG information affecting financial estimates: qualification and quantification

Once financial impact is qualified, the extent on financial estimates needs to be quantified:

ESG Information

Financial
Impact

Extent of Impact

Direct Impact Indirect Impact

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What extra-financial information matters to firms?

ESG Factors may affect the financial accounts in different ways

Energy efficiency
Sales
GHG emissions
Cost of goods sold
Staff turnover
Gross operating profit
Training & qualification
SG&A expenses
Remuneration
EBITDA
Litigation risks
Corruption
? Depreciation & amortization
EBIT
Innovation
Interest expense
Waste and recycling
Pretax income
Packaging
Income taxes
Water consumption
Net income
Consumer satisfaction
Example: Consumer Electronics.

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What extra-financial information matters to firms?

ESG Factors may affect the financial accounts in different ways

Energy efficiency
Sales
GHG emissions
Cost of goods sold
Staff turnover
Gross operating profit
Training & qualification
SG&A expenses
Remuneration
EBITDA
Litigation risks
Depreciation & amortization
Corruption
EBIT
Innovation
Interest expense
Waste and recycling
Pretax income
Packaging
Income taxes
Water consumption
Net income
Consumer satisfaction
Example: Consumer Electronics

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Examples of topics affecting the P&L Account:
SAP Integrated Report 2018 – Business Health Culture Index

Source: SAP (2018).

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Examples of topics affecting the P&L Account:
SAP Integrated Report 2018 – Business Health Culture Index

Sales 24,708
Cost of goods sold -7,462
Gross operating profit 17,246

SG&A expenses -10,181

EBITDA 7,065
Depreciation & -1,362
amortization Non-financial Indicator 2018 EBIT EBIT
EBIT 5,703 2019 (+2%) 2019 (-2%)

Interest expense -103 BHCI Index 87 5893 (3.3 %) 5513 (-6.4%)

Pretax income 5,600 Employee engagement 84 5813 (1.9%) 5593 (-3.8%)

Income taxes 1,511 Retention 93.3 5823(2.1.%) 5583 (-4.1%)

Net income 4,088 Emissions (kilotons CO2) 310 5715(0.2%) 5691 (-0.4%)

Source: SAP (2018), in € millions.

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7.2.1. ESG integration in valuation models: Equities
Examples of topics affecting the P&L Account: Bloomberg ESG valuation model

Source: Bloomberg ESG Evaluation Tool (2019).

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Examples of topics affecting the P&L Account: Sales

Challenge Topic KPIs to be used to analyse topic Potential impacts on financial forecasting &
Valuation
Social Low product safety Product recalls in history This would mean lower sales and potentially fines
(extraordinary costs) to be paid
Social Low labour standards and poor human capital Higher absenteeism Lack of motivation to sell more could mean lower
policy Higher turnover rate volumes sold or higher likelihood that employees go
Low employee satisfaction on strike (lower volumes)

Social Minimum or competitive salaries Lower turnover rate

Higher employee satisfaction
Social A new innovative product, that helps to solve Importance of innovation in Higher volumes and possible higher prices, since this
one global challenge company’s strategy is a unique product, where a high demand is
expected.

Environmental Climate change impact on water resources Water intensity (high) This would mean a high operational risk for the
(external issues that need to be managed) Operations in water-stressed company. In case of lack of water, e.g. due to
regions (high) drought, we would see a shutdown of the plant and
therefore impact on production volumes

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Examples of topics affecting the P&L Account: Costs

Challenge Topic Metrics Integration financial forecasting & Valuation

Social Low product safety Product recalls in history This would mean lower sales and potentially fines
(extraordinary costs) to be paid

Environment Environmental regulation (external issues that Carbon intensity CO2 prices x emissions volume
need to be managed) Emissions

Environment Climate change impact on water resources Water intensity (high) Higher input costs
(external issues that need to be managed) Operations in water-stressed High operational risk may impact company
regions (high) production volumes

Environment More stringent environmental regulation on The average diesel vehicle emits Look at the exposure to diesel and petrol.
“real world“ NOx emissions testing procedures in seven times more NOx emissions Increasing pressure on costs for vehicle
the auto industry (external issues that need to under real driving conditions than manufacturers to comply with the more stringent
be managed) stated regulations and therefore will experience lower
margins.

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Examples of topics affecting the Cash-Flow: CAPEX

Challenge Topic Metrics Integration financial forecasting & Valuation

Environmental More stringent environmental regulation on Research & Development: Need to Increasing pressure on capex
“real world” NOx emissions testing procedures in analyse how much percent of the
the auto industry R&D capex is going from internal
combustion engine efficiency to
greater electrification (e.g. hybrid,
plug-in hybrid and pure electric)

Environmental Gains from environmental initiatives Less water use, more circular Increasing pressure on capex
economy, higher efforts to reduce Lower costs and higher operational efficiency and
energy demand, etc. margins

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Examples of topics affecting the terminal value

Challenge Topic Metrics Integration financial forecasting & Valuation

Environmental/ Value intangibles Identifiable non-monetary asset Trademarks, patented technology and computer
Social without physical substance software.
Sometimes accounted as goodwill, others implicit
in valuation
(i.e. customer lists, supplier relationships, etc.)
Environmental Climate change Exposure to fossil fuels… e.g. coal Current value in the Balance-sheet and your
plants, reserves, coal reserves estimate for Terminal Value.
Coal as stranded asset as a political reaction on
climate change might affect your value estimate.

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Impact of ESG drivers on terminal value
The case of “Stranded assets”
Definition
§ There are a number of definitions of stranded assets (economic loss, stranded costs, financial loss, etc)
§ Caldecott, Howarth, and MacSharry (2013) proposed a “meta” definition to encompass all of these different definitions.
“Stranded assets are assets that have suffered from unanticipated or premature write-downs, devaluations, or conversion to liabilities“
Different causes :
§ Regulation and legislation (EU Plant Commission Directive, safety regulations…)
§ Lack of demand (innovation in renewables, that lower their price and makes some industries like Deepwater become non-competitive).
§ Market forces
§ Disruptive innovation
§ Development of circular economy that reduces the need for new extracted resources
§ Societal norms
§ Environmental shocks

Source: Caldecott, Howarth, and MacSharry (2013)

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Impact of ESG drivers on risk premium

Impact on discount rates through ESG factors:

! "! ($%&' %( $)*+'),)

"" ("+&. ("// ")'/) 0! ! "# − "" ("+&. *"/2+32)

Traditional components ESG components

§ Business cycle § Regulatory

§ Refinancing § Innovation
§ Market/ to Book § Non-quantifiable ESG
§ Market Cap Risks
§ Quality of governance

à Adding ESG information improves the quality of the discount factor

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Examples of topics affecting the valuation

Discount rate, risk premium and/or perpetuity growth rate

Challenge Topic Metrics Integration financial forecasting & valuation

Governance,
controversies and ESG Quality of governance § Lack of board independence Increase in the discount rate or risk
risk litigations premium.
§ Lack of appropriate board expertise
§ Inappropriate remuneration systems
§ Fraud and accounting risks
§ Antitakeover mechanism, etc.

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Example ESG integration in valuation

Source: West LB Research

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Topics affecting the financial statements and risk premium – Example: Climate change risk

Source: TCFD.

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7.2.2. Fixed income

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7.2.2. ESG integration in valuation models: Fixed income
Value of integrating ESG in the bond analysis

The value of integrating ESG factors in the bond analysis among others comes from:

§ Using them as early indicators, such as through exposing inadequate management oversight and
§ Assessing future environmental and social policies to better evaluate the quality of governance, as well as the sustainability of the
business model.
§ Assessing and potentially anticipating deteriorating credit conditions or risk of default- even before traditional financial metrics worsen.

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7.2.2. ESG integration in valuation models: Fixed income
Determination of materiality

“Materiality considerations in fixed income are more multi-dimensional than for equities”.

Theoretically, in fixed income there are different instruments with different maturities, which may make an ESG issue more or less relevant,
depending on the time frame in which it is likely to play out. But is this true in reality?

The materiality of ESG issues from a credit risk perspective depends on many factors, such as :
§ The financial profile of an entity
§ Its sector and geographical location
§ Type and characteristics of a bond

Source: PRI

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7.2.2. ESG integration in valuation models: Fixed income
Bonds: Credit–value from a risk mitigation perspective
Introduction: Materiality in credit risk assessment (I)

1. The materiality of ESG factors may be different based on:

§ investor’s motivation,
§ investment objectives (e.g. some seek more duration than others and consequently are more sensitive to long-term risks),
§ if the credit risk assessment should be made for a bond issuer or a single issue
§ type of credit (investment grade vs high yield vs. sovereign) and
§ strategies (alpha vs beta investing)

2. ESG considerations are helpful to manage downside risks (broader risk analysis), but also to enhance portfolio returns.

Source: PRI

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Bonds: Credit–value from a risk mitigation perspective
Introduction: Materiality in credit risk assessment (II)

3. As in equities, governance plays an important role in credit risk analysis. Since it influences management decisions, such as: business
development strategies; environmental and labour force policies; size, diversification and competitive position; and financial policy
(e.g. degree of leverage, etc.).

4. Materiality of environmental and social factors depends on sectors and regions

5. Consider changes in materiality for different durations (When will an ESG factor be material?)

6. Conduct ESG analysis for subsidiary and parent company

Source: PRI

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Bonds: Credit–value from a risk mitigation perspective
Introduction: Relevant time horizons to consider

1. The longer the time horizon, the more sensitive to long-term risks (e.g. investments in private debt instruments, etc.)

2. Time horizons depend on the maturity of a bond and/or whether a company generates enough cash flow to meet the debt
repayment.

3. Timing of ESG factors’ impact is key to the assessment.

à The key challenge is how to scrutinize ESG information to push a more forward-looking analysis more adjusted to the relevant
time horizons.

Source: PRI

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Focus

The focus of integrating ESG factors into the credit analysis is on

§ relative creditworthiness through assessment of a bond issuer’s fundraising ability

§ its cash flow generation, and

§ whether this is sufficient to honor debt commitment including at redemption- in full and on time.

Source: PRI

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Areas of analysis informing the valuation process are among others
Identification of ESG Value Drivers

Analysis of long-term structural ESG trends

§ Tend to influence ESG risks Analysis of corporate governance,

environmental and social challenges
Analysis of potential materialization of ESG-
related incidents

§ Probability and timing Consistency with the business model

§ Risk of such events recurring
Assessment of impact

§ Ability to adjust its business model

§ On issuer‘s credit fundamentals (cash-
flows and balance sheet)

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Business risk profile: Assessment

Regulatory/
Development Competitive
Country Risk Industry Risk Legal
Strategy Position
Framework

à Although the management of certain ESG issues might not have a material impact on the credit profile of the company
over the short-term, these risks may linger and affect the company’s ability to repay its debt over longer periods of time.

Source: PRI

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Business risk profile: Assessment

Pension Liabilities,
Profitability and cash
Operational risk past track record,
flow
refinancing costs

Capital Structure Liquidity R&D Expenditures Lititgation Costs

Source: PRI

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Impact on Cash flow estimates: Examples of qualitative risks and opportunities

Challenge Topic Metrics Integration creditworthiness assessment &

valuation possible impacts
Environmental Operations in a water- § Level of water stress in the regions of operations 1. Temporary stoppage of operations and/or loss
stressed region, being § Water consumed (level of materiality for production of the license to operate and therefore lower
water a critical input for process) sales
the production process. § Balance consumption between communities and 2. Higher capex, since other solutions may need
business: The use of fresh water is increasingly to be put in place, e.g. building a desalination
contested between companies and local plant
communities creating disputes and risks to the
operations. 3. Impact on
ü“permit delays for new projects”,
ütherefore costs overrunning and
üdelay in the revenues and earnings
contribution expected to come from new
business.

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Impact on risk estimates: Examples

Challenge Topic Metrics Integration creditworthiness assessment &

valuation possible impacts
Governance
-Antitrust & Look at number and gravity Have a negative impact on the risk profile if
-Corruption issues, etc. (very severe, severe, high, medium, low) of controversial several pending/open issues, no proactive
incidents corrective actions, low governance quality, etc.
(based on: impact on stakeholders, company reaction,
etc.) Contribute to higher costs in the form of
litigation, fines and increased regulation

Governance Quality of governance § Lack of board independence

§ Lack of appropriate board expertise
§ Inappropriate remuneration systems Increase in the discount rate or risk premium.
§ Fraud and accounting risks
§ Governance structure that leaves few rights to
minority shareholders, etc.

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Risk assessment sector by sector is crucial: e.g. for airlines

Sector Topic Impact Questions to be asked

Airlines Regulation: Pace of growth What is the relationship with local governments and policy makers?
market access

Regulation: ownership and Industry structure Does company management exert too much control?
control, competition policy

Infrastructure constraints Pace of growth How will the development of air traffic control infrastructure impact your
capacity for growth?

Labour relations Pace of growth & operation How does the company engage with workers and resolve labour issues as they
disruption arise?

Environmental Footprint Cost development Given increasing regulatory attention to aircraft emissions, what is the
company’s strategy to manage its carbon footprint?

Source: HSBC

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High yield: ESG valuation

§ Some additional considerations…

§ High yield issuers, by nature, are more susceptible to impacts from ESG risks.
§ Issuers tend to be smaller, many are private companies
§ The ESG disclosure tends to be very limited
§ They are more likely to have unconventional governance structures that may be misaligned with creditor interests
§ Quality of governance is even more central to the process of determining creditworthiness.
§ There is a higher need for investors to focus on an issuer’s capacity to survive low-impact/high-frequency events

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Private placements: ESG valuation

§ Private placements are tradable debt securities issued to a relatively small and select group of investors.
§ These investors tend to take a buy-and-hold approach because the market is relatively illiquid.
§ Credit ratings for privately placed bonds are issued after the bond is issued, and the average issuance period is 12 weeks.
§ The integration of ESG aspects in the analysis and valuation of private placements is especially important and useful, since:
1. Relatively poor transparency, the lack of divestment options and relatively large ticket sizes require thorough investor due
diligence
2. Longer issuance periods allow investors to engage issuers and identify ESG risks before committing to invest.
3. Investors can also use ESG concerns to negotiate with issuers on coupons due to the relatively close relationship between
both parties
4. Investors can take the opportunity to impose disclosure and reporting requirements to more precisely address ESG
concerns.

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Introduction: ESG integration in sovereigns

§ Different ESG criteria are used for the sovereign analysis rather than for the corporates one

§ Sovereigns have different goals and aspirations

§ Sovereigns do not pursue narrow economic goals or profit maximization, but rather “create and sustain public goods”

Source: HSBC.

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ESG Integration in sovereign analysis: Objectives

Sovereign analysis

Government ability to pay its obligations Willingness to pay

(Business and financial assessments) (Governance assessment)

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ESG Integration in sovereign analysis: Objectives

§ Focus is to identify the ESG risks that can have a dramatic impact on the future GDP growth, such as e.g. stranded assets, extreme
climate events or carbon taxes.

§ It is key to identify specific ESG criteria that do have a material impact for a given level of development expressed in GDP/Per Capita
(the relevant ESG factors of advanced economies are very different from developing economies)

§ It is key to select ESG factors that can be used as advanced signals of asymmetry

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A combined assessment: ESG contribution

Business & Financial Assessment:

§ Debt sustainability analysis: Can a country grow fast enough to outpace the rate at which it accumulates debt?
§ Debt basically grows as a result of primary deficits and real interest rates.
§ GDP growth must outpace this path of accumulation (central factor of analysis).

Reasons for ESG Assessment:

§ Sovereign economic growth and stability are critically influenced by the quality of governance.
§ Environmental and social factors matter because they have consequences for economic development.

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7.2.2. ESG integration in valuation models: Fixed income – Bonds
What kind of ESG factors should be considered in ESG sovereign assessments?

Governance factors: Provide the foundation for development

§ Absence or presence of corruption

1.

§ Respect, or not, of the rule of law

2.
§ Exessive influence, or not, of a powerful family/particular ethnic group
3.

§ Credibility and effectiveness of monetary & fiscal policy

4.

§ Bad governance might entail a government looking to divert state cash flows towards armament or for personal gain
5.
Source: HSBC.

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7.2.2. ESG integration in valuation models: Fixed income – Sovereigns
What kind of ESG factors should be considered in ESG sovereign assessments?

Social factors: Can impact economic growth

§ Life expectancy
1.

§ Level of education the citizens enjoy

2.
§ Level of social expenditure and social safety
3.

§ Access to affordable housing

4.

§ Labour rights and access to basic services (healthcare, banking services, internet, etc.)
5.
Source: HSBC

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7.2.2. ESG integration in valuation models: Fixed income – Bonds
What kind of ESG factors should be considered in ESG sovereign assessments?

Environmental factors: Can impact economic growth

§ Exposure to climate change: damage risk

1. (impact on costs coming from: e.g. Persistent heat waves, drought, collapse of agricultural yields, excessive rainfall,
rising sea levels, sea storm surges, spread of water-borne diseases)

§ Exposure to climate change: transition risk (impact on "business model" on e.g. countries that are very reliant on fossil
2.
fuel exports)

§ Water access and management

§ Food security and management
3. § Energy access and management
§ Emissions & environmental policies

Source: HSBC

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7.2.2. ESG integration in valuation models: Fixed income – Bonds
Interrelation of ESG factors in sovereign analysis: especially important in developing
countries
§ Most developing countries face some degree of shortfall when it comes to
governance.
Social crisis/ climate
§ These countries often exhibit higher levels of migration, under-employment, change damage
inequality and marginalization.
§ Many of these countries are located in areas that are projected to suffer
disproportionately from climate change, with the brunt of the impact falling on
residents who already have a lower quality of life.
Ineffective reaction and
§ The confluence of these elements --weak governance, environmental stress and impact on economic
social strain-- results in heightened vulnerability to environmental and social
development
shocks, since they trigger a negative cascade of effects.

Weak Governance

Source: Western Asset.

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7.2.2. ESG integration in valuation models: Fixed income – Sovereigns
ESG factors in sovereign analysis: example sustainalytics

Source: Sustainalytics.

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7.2.2. ESG integration in valuation models: Fixed income
Green and social bonds

Apart from having some information on the project that will be financed through the green or social bond emission, green
bonds are valued in the same way as credit and sovereign bonds.

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7.2.3. Infrastructure

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7.2.3. ESG integration in valuation models: Infrastructure
Private Infrastructure equity & debt

§ In finance, infrastructure refers to the underlying and fundamental assets and systems that facilitate functions that are
necessary to the well-being of an economy.

§ Mansour and Nadji (2006) separate infrastructure investments into the two broad categories of economic and social
infrastructure.

Source: Alternative investments CAIA I.

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7.2.3. ESG integration in valuation models: Infrastructure
ESG material issues (I)

§ Materiality will vary according to factors including size and type of asset, region, operational environment and stage of project cycle.
§ The impact of an asset on the natural environment and local community tends to be significant during the development and
construction of greenfield projects.
§ Stakeholder management from an early stage can be key to obtaining and maintaining the legal and social license to operate
§ The resilience of the asset to future ESG risks can also be influenced during the development phase: preparedness for environmental
and social risks, as well as updates to construction standards. Design and contractor requirements can facilitate future risk
management.
§ In Brownfield infrastructure the ESG risks relate both to the ongoing operation, reconstruction, renovation or expansion of an existing
asset, and to long-term trends which may materialize slowly and for which the business needs to prepare.

Source: PRI

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7.2.3. ESG integration in valuation models: Infrastructure
ESG material issues (II)

ESG concerns may affect:

1. Timelines

2. Licence to operate

3. Economic viability

Source: PRI

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7.2.3. ESG integration in valuation models: Infrastructure
ESG material issues (III)

ESG issues that need to be analyzed in Infrastructure projects:

§ Maintaining social licence to operate § Climate change impact and additionally

§ Health & Safety standards (pre- and post- commercial § Resource scarcity and degradation
operation date) § Extreme weather events
§ Biodiversity impacts § Supply chain sustainability
§ Alignment of interest with shareholders § Accountability
§ Stakeholder management and community relations § Board independence and conflicts of interest
§ Labour standards § Management and board oversight of ESG
§ Land rights, indigenous rights § Bribery and corruption
§ Accessibility and social inclusion § Tax policy/ Cyber security
§ Service reliability § Diversity and anti-discrimination

Source: PRI

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7.2.3. ESG integration in valuation models: Infrastructure
Example of management strategies

§ Anticipating environmental risk

§ Stakeholder management from an early stage: key to obtain and maintain the legal and social licence to operate.
Engagement program could be structured along the following lines:
§ Partnering with contractors on a range of innovative legacy projects during construction
§ Identifying and delivering such projects
§ Assessing local community interest in investing directly in the project.
§ Establishing a benefit fund to support longer-term community initiatives

Source: PRI

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7.2.4. Other asset classes

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7.2.4. ESG integration in valuation models : Other asset classes
Real Estate – Material issues

Source: PRI

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7.2.4. ESG integration in valuation models : Other asset classes
Real Estate – Material issues affecting cost and revenues

There are many ways that ESG issues can affect the valuation, including:
§ discount due to additional capital expenditure, e.g.: upgrade equipment to improve energy performance;
§ discount due to future income uncertainty, e.g:. buildings that do not meet minimum energy performance
standards set by legislation;
§ discount due to obsolescence risk, e.g.: low-quality buildings have a shorter life;
§ deal abandonment due to unacceptable risks identified during due diligence, e.g.: inadequate fire
protection, high likelihood of natural disaster, land contamination.

Source: PRI

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7.2.4. ESG integration in valuation models : Other asset classes
Real Estate – Active management affecting cost and revenues

Source: PRI

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7.2.4. ESG integration in valuation models : Other asset classes
Private Equity – Due diligence and investment decision (I)

1. Due diligence
§ Screening: The initial screening of an investment opportunity can provide an early-stage assessment
on how it aligns with the ESG objectives.
§ Company deep dive: Due diligence on ESG factors (through desk research and site visits) is an
iterative process with repeated interaction between the different actors (the portfolio company,
investment manager, external ESG consultant and/or internal dedicated team of ESG operational
specialists). High-level checks may also look at the sectoral and geographic-related ESG risks and
opportunities. A periodical review of this list incorporates new developments or insights which may
significantly influence its composition.
§ Exclusion of controversial industries and activities, (e.g.: cluster munitions), or follow the UN and EU
guidelines on country exclusion.

Source: PRI

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7.2.4. ESG integration in valuation models : Other asset classes
Private Equity – Due diligence and investment decision (II)

2. Investment decision
§ Inclusion of ESG considerations as standard practice in investment committee discussions.
§ Inclusion of key ESG findings collected during the due diligence in the investment memorandum, in
order to ensure that the investment committee is informed on ESG matters.
§ Inclusion of a separate section in the investment memorandum, even if no ESG risks were identified,
as it will demonstrate that a thorough focus on ESG matters was performed during due diligence.
§ Indication of how the target company performs relative to its peers.

Source: PRI

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7.2.4. ESG integration in valuation models: Other asset classes
Private Equity – TCFD integration

Source: PRI

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Takeaway

§ Material ESG topics affect the financial estimates and the forecasts thereof.
§ In equity valuation it is essential to integrate this information in order to obtain a better estimate for the equity value.
§ In fixed income valuation we focus on a company’s relative credit-worthiness and its ability to generate cash flow.
§ In sovereign analysis we look at a government’s ability and willingness to pay its obligations.

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Example Valuation

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Example: Valuation integrating ESG
Equity Valuation – Steps

1. Identification of material ESG issues and of how these topics affect the financial estimates for the cash flow recognition
(make assumptions based on comparable cases and market analyses).

2. Model the cash flow for the detailed planning period (5 years), excluding the adjustments for the material ESG topics;
calculate the terminal value, enterprise value and value per share.

3. Model the cash flow for the detailed planning period (5 years), including the adjustments for the material ESG topics;
calculate the terminal value, enterprise value and value per share.

4. Compare both calculations.

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Example: Valuation integrating ESG
Equity Valuation – Assumptions - automotive company financials
For the financial forecasts we have the following
assumptions: Further considerations for the detailed forecasting period
are given:
Assumptions values in kUSD
Tax Rate 25.0%
Cost of debt 6.0% § The revenues in t0 are 1,800,000 kUSD; the financial
Cost of equity 15.0% forecast assumes a growth rate of 8% in t1, 5% in t2
Equity Ratio 40.0% and 3% for t3-t5.
Cost of capital 9.60%
Perpetural Growth Rate 1.5% § The EBIT Margin in t0 is 5% and is stable over the years.
Evaluation Date 31.12.2020
Fiscal Year End 31.12.2020 § Depreciation and amortization have the same amount
Current share price (in USD) 20 as regular CAPEX and Net Working Capital (NWC).
Outstanding shares (in k) 20,000
Debt 600,000
Total Debt service 81,521
Cash 40,000
Capex and NWC 7,500
*The calculations were made with Excel, so there may be small rounding differences. If you perform the calculation yourself, please round to two decimal places.

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Example: Valuation integrating ESG
Equity Valuation – Identification and assessment of material ESG topics

Material ESG Topic Effects on financial statements Assumptions for financial estimates

❶ Recent reputational damage due to litigation Reputational damage leads to a decline in (i): Expected decrease in revenues: Year 1 -6%, Year 2 -
over mistreatment of employees. sales numbers (revenues). 3%, Year -1.5 %.

❷ Anticipated additional tax payments. Additional tax payments will reduce the (ii): Expected additional tax payments 10,000 in year 1
NOPLAT (Net operating profit less adjusted and year 2 and 5,000 in year 3 (in kUSD).
taxes)
❸ The company wants to reposition itself and For the installment phase, higher CAPEX (iii): Expected investment volume: 67,500 over the next
produce more efficient batteries than its are expected 5 years; 30,000 in year 1; 20,000 in year 2; 10,000 in
competitors in order to become the market year 3; 5,000 in year 4; and 2,500 in year 5 (in kUSD).
leader for electric cars with new technology, After this takes place, an increase in (iv): Expected increase in revenue: Year 4: 6%; year 5:
i.e.: an increase in market share is expected market share is expected. 3%.
after the investments have been made and the
installment phase has been started.

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 The calculations were made with Excel, so there may be small rounding differences.

Example: Valuation integrating ESG If you perform the calculation yourself, please round to two decimal places.

Equity Valuation – Cash flow valuation without ESG adjustments

❶ Time Periods 2020 2021 2022 2023 2024 2025 Terminal Value
Values in kUSD Actual Forecast Forecast Forecast Forecast Forecast Forecast
Time Periods 0 1 2 3 4 5 Assumption in
Cash Flow Items growth rates
Operational revenues 1,800,000 1,944,000 2,041,200 2,102,436 2,165,509 2,230,474
Less: Operational costs -1,710,000 -1,846,800 -1,939,140 -1,997,314 -2,057,234 -2,118,951
Operational EBIT (5% EBIT Margin) 90,000 97,200 102,060 105,122 108,275 111,524 EBIT Margin 5%
Less: Operational Taxes -22,500 -24,300 -25,515 -26,280 -27,069 -27,881
Tax Rate 25%
Operational NOPLAT 67,500 72,900 76,545 78,841 81,207 83,643
Add: Depreciation and amortization 7,500 7,500 7,500 7,500 7,500 7,500 Assumption CAPEX
Less: Regular Capex and NWC -7,500 -7,500 -7,500 -7,500 -7,500 -7,500 and CAPEX = D&A
Unlevered Free Cash Flow 67,500 72,900 76,545 78,841 81,207 83,643 1,048,116 and NWC
Discounted Free Cash Flows 66,515 63,723 59,886 56,279 52,890 662,761

❷ Enterprise value 962,053

Detailed Forecast Period (5 Years) Terminal Value
Plus: Cash 40,000
Less: Debt -600,000 89'& 1 + <
Intrinsic Equity Value 402,053 &
20
89! "−<
Equity Value/ Share !4'/"*"+&/ 5),3/ = 7 +
1+" ! 1+" &
!$%

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 The calculations were made with Excel, so there may be small rounding differences.

Example: Valuation integrating ESG If you perform the calculation yourself, please round to two decimal places.

Equity Valuation – Cash flow valuation including ESG adjustment

Terminal
Time Periods 2020 2021 2022 2023 2024 2025 Value ESG adjustments ESG factors
Values in kUSD Actual Forecast Forecast Forecast Forecast Forecast Forecast
0 1 2 3 4 5
Cash Flow Items
Operational revenues 1,800,000 1,944,000 2,041,200 2,102,436 2,165,509 2,230,474
(i) Year 0 to 3 reduced sales due to ongoing litigation case due to S - Social
❶ bad employee treatment associated with reputational damage
& Less: Decrease in operational revenues -116,640 -61,236 -31,537 129,931 66,914 (ii) Year 4 to 5 increase in market share due to better products E - Environmental
❸ (i) Expected decrease: Year 1 -6%, Year 2 -3%, Year -1.5 % S - Social
% Decrease in operational revenues -6% -3% -1.5% 6% 3% (ii) Expected increase: Year 4 - 6%, Year 5 - 3% E - Environmental
Revenues after ESG adjustment 1,800,000 1,827,360 1,979,964 2,070,899 2,295,440 2,297,389
Less: Operational costs -1,710,000 -1,735,992 -1,880,966 -1,967,354 -2,180,668 -2,182,519
Operational EBIT (EBIT Margin 5%) 90,000 91,368 98,998 103,545 114,772 114,869
Less: Operational Taxes -22,500 -22,842 -24,750 -25,886 -28,693 -28,717
Operational NOPLAT 67,500 68,526 74,249 77,659 86,079 86,152
Less: Additional taxes -10,000 -10,000 -5,000 0 0 Additional tax payments due to tax avoidance G - Governance
❷ Expected payments 10,000 in year 1 and year 2 and 5,000 in year
3 G - Governance
NOPLAT after ESG adjustment 67,500 58,526 64,249 72,659 86,079 86,152
Add: Depreciation and amortization 7,500 7,500 7,500 7,500 7,500 7,500
Less: Regular Capex and NWC -7,500 -7,500 -7,500 -7,500 -7,500 -7,500
❸ Less: Additional CAPEX -30,000 -20,000 -10,000 -5,000 -2,500 Additional investments to develop better electric batteries E- Environmental
% Additional CAPEX (67.500) 44% 30% 15% 7% 4% Expected investment volume 67.500 over the next 5 years E- Environmental
Unlevered FCF after ESG adjustment 67,500 28,526 44,249 62,659 81,079 83,652 1,048,233
Discounted FCF 26,027 36,837 47,594 56,191 52,896 662,834

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 The calculations were made with Excel, so there may be small rounding differences.

Example: Valuation integrating ESG If you perform the calculation yourself, please round to two decimal places.

Equity Valuation – Cash flow valuation including ESG adjustment

❶ Time Periods 2020 2021 2022 2023 2024 2025Terminal Value

Values in kUSD Actual Forecast Forecast Forecast Forecast ForecastForecast
0 1 2 3 4 5
Unlevered free cash flow after ESG adjustment 67,500 28,526 44,249 62,659 81,079 83,652 1,048,233
Discounted Free Cash Flows 26,027 36,837 47,594 56,191 52,896 662,834

❷ Enterprise value after ESG adjustment 882,379 Detailed Forecast Period (5 Years) Terminal Value
Plus: Cash 40,000
89'& 1 + <
&
Less: Debt -600,000 89! "−<
!4'/"*"+&/ 5),3/ = 7 +
1+" ! 1+" &
Intrinsic Equity Value 322,379 !$%
Equity Value/ Share 16
The adjustments made, based on the
Equity Share Value without ESG considered material ESG topics, result in a
Corrections 20 significant lower share price.

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Example: Valuation integrating ESG
Bond Valuation – Steps

1. Identification of material ESG issues and of how these topics affect the financial estimates for assessing the ability to
repay debt (make assumptions based on comparable cases and market analyses).

2. Model the financial estimates for the bond period without ESG adjustments.

3. Model the financial estimates for the bond period including ESG adjustments.

4. Compare the free cash flows and other financial estimates, such as debt service coverage ratio.

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 The calculations were made with Excel, so there may be small rounding differences.

Example: Valuation integrating ESG If you perform the calculation yourself, please round to two decimal places.

Bond Valuation – Assumptions in automotive company financials

For the financial forecasts, we have the following
assumptions: Further Information is given:

Assumptions values in kUSD

Tax Rate 25.0% § Revaluation of corporate bond with 5-years to maturity.
Cost of debt 6.0%
Cost of equity 15.0% § The annual total debt service is 81,521 kUSD.
Equity ratio 40.0%
Cost of capital 9.60%
Perpetual growth rate 1.5%
Evaluation date 31.12.2020
Fiscal year end 31.12.2020
Current share price (in USD) 20
Outstanding shares (in k) 20,000
Debt 600,000
Total debt service 81,521
Cash 40,000
Capex and NWC 7,500

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 The calculations were made with Excel, so there may be small rounding differences.

Example: Valuation integrating ESG If you perform the calculation yourself, please round to two decimal places.

Bond valuation – Cash flow and debt service coverage ratio without ESG adjustments

2021 2022 2023 2024 2025 2026 Free Cash Flow recognition
Values in kUSD Actual Forecast Forecast Forecast Forecast Forecast the same as in equity
Time Periods 0 1 2 3 4 5
Cash Flow Items valuation
Operational revenues 1,800,000 1,944,000 2,041,200 2,102,436 2,165,509 2,230,474
Less: Operational costs -1,710,000 -1,846,800 -1,939,140 -1,997,314 -2,057,234 -2,118,951
Operational EBIT 90,000 97,200 102,060 105,122 108,275 111,524
Less: Operational Taxes -22,500 -24,300 -25,515 -26,280 -27,069 -27,881
Operational NOPLAT 67,500 72,900 76,545 78,841 81,207 83,643 EBITDA = Operational EBIT +
Add: Depreciation and amortization 7,500 7,500 7,500 7,500 7,500 7,500 Depreciation and amortization
Less: Regular Capex and NWC -7,500 -7,500 -7,500 -7,500 -7,500 -7,500
Unlevered free cash flow 67,500 72,900 76,545 78,841 81,207 83,643
Discounted free cash flows 66,515 63,723 59,886 56,279 52,890

Debt service coverage ratio (include CAPEX) 1.196 1.284 1.344 1.382 1.420 1.460
Debt service coverage ratio (exclude CAPEX) 1.104 1.192 1.252 1.290 1.328 1.368

0123!4
!"#$ %"&'()" *+'"&,-" .,$(+ =
3+$,5 !"#$ %"&'()"

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 The calculations were made with Excel, so there may be small rounding differences.

Example: Valuation integrating ESG If you perform the calculation yourself, please round to two decimal places.

Bond valuation – Cash flow and debt service coverage ratio including ESG adjustments
Time Periods 2020 2021 2022 2023 2024 2025
Values in kUSD Actual
0
Forecast
1
Forecast
2
Forecast
3
Forecast
4
Forecast
5
Free Cash Flow recognition
Cash Flow Items the same as in equity
Operational revenues 1,800,000 1,944,000 2,041,200 2,102,436 2,165,509 2,230,474
Less: Decrease in operational revenues -116,640 -61,236 -31,537 129,931 66,914 valuation
% Decrease in operational revenues
❶&❸ -6% -3% -1.5% 6% 3%
Revenues after ESG adjustment 1,800,000 1,827,360 1,979,964 2,070,899 2,295,440 2,297,389
Less: Operational costs -1,710,000 -1,735,992 -1,880,966 -1,967,354 -2,180,668 -2,182,519
Operational EBIT (EBIT Margin 5%) 90,000 91,368 98,998 103,545 114,772 114,869
Less: Operational Taxes -22,500 -22,842 -24,750 -25,886 -28,693 -28,717
Operational NOPLAT 67,500 68,526 74,249 77,659 86,079 86,152
Less: Additional taxes ❷ -10,000 -10,000 -5,000 0 0

NOPLAT after ESG adjustment 67,500 58,526 64,249 72,659 86,079 86,152
Add: Depreciation and amortization 7,500 7,500 7,500 7,500 7,500 7,500
Less: Regular Capex and NWC -7,500 -7,500 -7,500 -7,500 -7,500 -7,500
§ Debt service coverage
Less: Additional CAPEX
❸
-30,000 -20,000 -10,000 -5,000 -2,500 ratio after
% Additional CAPEX (67.500) 44% 30% 15% 7% 4%
Unlevered free cash flow after ESG adjustment 67,500 28,526 44,249 62,659 81,079 83,652
considering ESG
Discounted Cash Flows 26,027 36,837 47,594 56,191 52,896 material topics and
necessary increase in
Time Periods 2020 2021 2022 2023 2024 2025 Average Value CAPEX is lower.
Actual Forecast Forecast Forecast Forecast Forecast
Debt service coverage ratio (include CAPEX) (ESG adjusted) 1.196 1.213 1.306 1.362 1.500 1.501 1.376
§ Increase in risk
Debt service coverage ratio (exclude CAPEX) (ESG adjusted) 1.104 0.753 0.969 1.147 1.347 1.378 1.119 premium.
Debt service coverage ratio (include CAPEX) (not ESG adjusted) 1.196 1.284 1.344 1.382 1.420 1.460 1.378
Debt service coverage ratio (exclude CAPEX) (not ESG adjusted) 1.104 1.192 1.252 1.290 1.328 1.368 1.286

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Example: Valuation integrating ESG
Additional Information on
Assumptions
Equity Valuation – Assumption for financial estimates

Forthe
For theimpact of the ESG material issues additional data related to peer firms, similar ESG related incidents and market
trends and developments need to be analyzed:

§ Labor issues: Use of historical incidents at similar companies (peers) in the region/sector to analyze impact on lost
contracts, production decline, and customer losses. (Case study Caravel Management).
§ Tax-avoidance: Analyses of the firm’s tax gap: the difference between the weighted average statutory tax rate for a
company based on its geographic sales mix and the effective tax rate shown on the company’s income statement. (Case
study MFS Investment Management).
§ Potential of the electric battery segment: Analysis of the market potential of the business segment. The market tends to
be slow to price in structural changes. Use of the company's target revenues and estimated market volume (Case study
Standard Life Investments).

Challenge: Combination of new and additional data sources to quantify effects.

Source: PRI (2017). A practical guide to ESG integration for equity investing.

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