Factoring ESG into deal valuation is now a necessity, not a Luxury

With COP 27 in full flow in Egypt, the emphasis on sustainability and ESG has never been more focussed.

Eight years ago, ESG and sustainable development were fringe notions amongst a small minority of organisations.

Today, however, they are one of the key strategies that both organisations, and investors, are focusing on as we strive to reach a net-zero world by 2050.

According to a KPMG report from February 2022, there is evidence suggesting private equity investors will pay a premium of up to 10 or 20 percent for a business with a sound ESG strategy.

The first metric that needs to be addressed by organisations, is the application of ESG analytics in financial analysis, which is still nascent.

The lack of a consistent framework around collecting, measuring and reporting ESG data is a common issue making comparisons between businesses – a key component of the market multiple approach – very difficult.

This is exaggerated by the lack of a standard methodology for incorporating ESG data and translating these into financial measurements, increasing the issue of “which data to trust”?

Added to this challenge are the sometimes-conflicting ESG ratings provided by various agencies.

Unfortunately, right now, there isn’t an off-the-shelf solution available for assessing ESG factors in valuation.

The preferred method is to make explicit adjustments in cash flow forecasts where possible.

However, this approach is not infallible.  Currently, the discounted cash flow approach assumes perpetual growth or an exit as a proxy for the terminal value.

An organisation needs to take into account the longer-term impact of physical risks whilst balancing that with the short to medium-term impact of an organisation’s transition to net zero.

Using an assessment framework, such as the one that Ascent Partners uses to identify ESG risks and opportunities material to the business and determine whether these are internal or external factors (e.g. specific to the company/asset or systemic), short or long-term, their materiality, their measurability, is critical.

Such a matrix can then be applied with other more traditional valuation considerations to assess the adjustments required to cash flow or, if appropriate, the discount rate.

Organisations that do not have a strong and committed ESG strategy will ultimately impact the growth opportunities of an organisation, and thereby its value.

By burying their head in the sand over ESG factors, organisations are not only leaving value on the table in the short term but more importantly, their viability in the long term.

For more information on ESG reporting, please contact Ascent Partners at: contact@ascent-partners.com