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More and more investors recognize the importance of ESG integration. However, many parties tend to focus on screening and exclusion. While lots of ESG efforts are being made, the connection to business models and valuation tends to be missing. In this article we discuss how the Robeco Global Equity team tackles the challenge of linking ESG to value drivers.
Many asset managers indicate that they integrate ESG into their investment processes. The most advanced parties tend to have the following elements:
These are all very useful and are part of Robeco’s toolbox as well. However, in our view they do not go far enough. True ESG integration goes one step further. The European Sustainable Investment Forum (Eurosif) defines ESG integration as follows:
“This type (of strategy) covers explicit consideration of ESG factors alongside financial factors in the mainstream analysis of investments. The integration process focuses on the potential impact of ESG issues on company financials (positive and negative), which in turn may affect the investment decision.”
This definitely goes well beyond screening and engagement, and implies the use of ESG information in all stages of the investment process, including the investment case and the valuation models used in investment decisions. At Robeco Global Equity, we do this because we firmly believe in the impact of ESG factors on the valuation of companies. In addition, we are in a unique position to quantify this impact as we have access to extensive, high-quality data obtained from the RobecoSAM Corporate Sustainability Assessment. This is based on questionnaires sent to over 2800 companies each year.
For every investment we do, the analyst makes an in-depth ‘investment case’ of the company, which states his or her opinion on the industry, company strategy, the product portfolio, competitiveness of the franchise and a SWOT analysis. To quantify stock potential we identify four value drivers: revenue growth, margin development, invested capital needed and risk (as defined by a discount factor). To assess the fair value of a stock, these four factors are combined in our proprietary valuation tool: the Value Dynamic Framework (VDF), which is a discounted cash flow (DCF) model that explicitly takes invested capital into account.
Quantifying the impact of ESG factors on companies’ valuation takes place in three steps. The first step is to focus on the most material issues, i.e. those ESG issues that may substantially affect the company’s business model and value drivers – either positively or negatively. The second step is to analyze the impact of these material factors on the individual company. The third step is to translate the associated competitive advantages and disadvantages into adjustments to value driver assumptions in valuation models.
The table below shows an example of how the ESG impact may be quantified for a chemicals company. In this case the ESG factors have a significant and positive impact on the value driver assumptions.
Even if the analyst decides to assign no impact to the value drivers (because the factors cancel each other out or the company is just average), these questions typically do give the analyst a deeper insight into the quality of company management and the risks involved.
With our proprietary Value Dynamic Framework valuation model, we have a firm foundation in traditional financial analysis, and we look forward to further enhancing it by quantifying the impact of ESG factors.