ESG and firm value - does it matter?
27 February 2020
Andrew Graham, Head of Asia, and Tom Wills, Portfolio Manager, investigate the importance of governance and sustainability considerations within company valuations.
Governance, sustainability & firm value - complementary investment essentials
A common criticism of governance and sustainability (‘G&S’ or more broadly, ‘ESG’) analysis is that it can sit as an isolated assessment of somewhat tenuous criteria that has little impact on the valuation assessment and investment decision. At Martin Currie we take a very different view.
Our G&S analysis forms an integral part of the investment process, and a key part of our assessment of company valuation.
Investing in sustainable businesses
We are the stewards of our clients’ capital, the value of which we aim to compound over many years by holding ownership stakes in high-quality, growing businesses. If we are investing in sustainable businesses, their own returns will, over time, do the natural compounding for us and long-term ownership will be especially rewarding.
This is possible because a good, well-managed cashgenerative business can reinvest profits back into its operations to fund future growth. Provided management effectively navigates future business environments while sustaining the company’s competitiveness, the human and physical capital it employs will create increasing value for shareholders over time.
Recognising this, we see it as self-evident that embracing this stewardship role entails not only careful consideration of individual company fundamentals, but also of the implicit long-term assumptions about those fundamentals embedded in share prices and the degree of confidence we ought to have that these assumptions are realistic.
If the relative quality of a business is characterised by its ability to earn a return in excess of its cost of capital (i.e. to extract an ‘economic rent’), then its attractiveness as an investment must be predicated on some notion that this excess return is sustainable.
This requires us to extend our fundamental assessment to consideration of the future use of capital and whether it will be allocated in ways beneficial to shareholders – this is as much a question of governance as it is of managerial ability. We also need to have confidence that management is future-proofing the business through active engagement with all stakeholders to ensure longterm sustainability.
Within this paper we take a closer look at long-term investing and valuation, examining why governance and sustainability analysis should lie at the heart of these. We also consider what implications there are for portfolio risk and how thinking about governance, sustainability and valuation together not only leads to more informed investment decision-making but also to active, valuecreating engagements with companies.
Focusing on the long-term
Growing the value of capital through long-term ownership of shares in companies requires that these are purchased at a sensible valuation, with serious miscalculation likely to destroy value. The potential for miscalculation is practically boundless.
Let’s begin with a quote from Aswath Damodaran, Professor of Finance at the Stern School of Business at New York University and author of several books on investment valuation, corporate finance and investing:
“To value an asset, we have to forecast the expected cash flows over its life. This can become a problem when valuing a publicly traded firm, which at least in theory can have a perpetual life. In discounted cash flow models, we usually resolve this problem by estimating cash flows for a period (usually specified to be an extraordinary growth period) and a terminal value at the end of the period.”1
Estimated future cash flows will typically account for the vast bulk of the intrinsic value of a business. To estimate cash flows, we make assumptions about growth of revenues, profit margins, capital intensity (both in terms of working capital requirements and the capital spending needed for maintenance and for growth), taxes, interest rates and potentially many more inputs. These assumptions will be the product of research on the company, an understanding of the competitive dynamics of its industrial sector and how broader trends in the economy impact the near- and longer-term outlook for that sector. It should be clear that reaching any conclusion about the attractiveness of a company’s stock involves a long string of assumptions, some made consciously and some implicitly.
Thinking about governance, sustainability and valuation together not only leads to more informed investment decision-making but also to active, value-creating engagements with companies.
Arriving at equity value
In the standard Martin Currie intrinsic value model (a discounted cash flow model), we split the period over which we estimate cash flows into three:
- An explicit forecast period (years 1-5), which ends with a ‘normal year’ – an approximation for what a company’s mid-cycle business metrics might look like;
- A ‘fade window’ or adjustment period (years 6-15) and;
- A terminal value (an estimated value for all the remaining cash flows the business may generate beyond the fade window).
These are discounted to present day values, using a cost of capital or discount rate, and summed to create a total firm value. We then add the value of investments and deduct net debt and minority interest in the firm value to arrive at an equity value. Most valuation approaches that have an intrinsic value component to them will do some version of the above.
Forecasting the future
Intrinsic valuation approaches are very much concerned with the future and how the variables that affect value creation may evolve over time. The problem is that forecasting the future is hard and human beings are demonstrably bad at it, even those who do it for a living.
Economies are complex adaptive systems that are inherently unpredictable. This unpredictability also extends to the agents acting within these systems, whether they be individuals or companies. The closer to the present we forecast, the greater the perceived ‘safety’ in forecasts (although this is frequently illusory), which probably explains why the bulk of our industry’s intellectual capital is expended on trying to forecast accurately the ‘front end’ of the explicit forecast period. The further into the future we peer, the less likely it becomes that our forecasts will even approximate what eventually unfolds. Reflecting this reality, a sensible analyst will fade the assumed economics of a business lower over an extended period (in Martin Currie’s case the fade window is usually 10 years).
Terminal value vs Firm value
The challenge in analysing most stocks is that the vast bulk of their future value resides in cash flows generated beyond the five-year explicit forecast period.
For growth stocks, this timeframe is likely to extend even further, with the bulk of value aligned with an expectation of returns created far off in the future i.e. terminal value forms a large component of overall firm value. This is not a reason to avoid such a stock, but an investor ought to be aware of this and be sure that current valuation adequately compensates for this.
Economies are complex adaptive systems that are inherently unpredictable. This unpredictability also extends to the agents acting within these systems, whether they be individuals or companies.
Let’s shed more light on this by briefly looking at two examples. The tables below show intrinsic value breakdowns for a low-growth and a high-growth stock (Hengan and Hindustan Unilever respectively). In both cases, the intrinsic value models have been ‘solved for the current share price’. That is, we have made assumptions about growth, profit margins etc., to ensure the derived equity value per share in the standard Martin Currie intrinsic value model approximates the current share price. In other words, we’ve used forecasts of the key variables that investors would implicitly be assuming if they believed the shares to be fairly valued today.
Figure 1: Cash flow projections for a low-growth company – Hengan:
Figure 2: Cash flow projections for a high-growth company – Hindustan Unilever:
Source: Martin Currie and Factset. As at December 2019.
You can see that even for the low-growth stock, 34% of the expected total firm value (EV) is dependent on the returns generated after year 15; for the high-growth stock, it is 67%. To put it another way, the proportion of terminal value in the total firm value is 97% greater for high-growth stock than for the low-growth one.
Only 10% of the high-growth company’s value comes from the first five years; while even for the low-growth company, 72% of total firm value is generated after year five. So, whether you are investing in a high-growth stock or a mature, low-growth stock, if you intend to be a longterm owner you must accept the reality that the bulk of that stock’s value resides in a hard-to-predict future. This needn’t put you off investing, but it demonstrates why having confidence in the sustainability of the business model is so important.
Forecasting the future
The knowledge that so much of the real or intrinsic value embedded in a share price is dependent on hoped-for returns from a distant and unpredictable future is daunting. So how, as investors, can we deal with this?
Firstly, we can flex the assumptions in our models to give us some sense of the margin for error – the wider this is, the better. If the current share price offers you upside across a range of reasonable assumptions and downside only on assumptions that would be untypical, based on your knowledge of the business, you can be more comfortable about investing. This is a valid approach and, if adopted, also helps to mentally prepare an investor for that unpredictable future.
Flexing assumptions helps us figure out what the stock market is pricing in about the sustainability of returns and what we need to believe to achieve our required rate of return (the latter being captured in the interest rate we use to discount future cash flow values to the present).
This is useful information, but if we are really planning to buy a stock, we must accept that perhaps 30–70% of the ‘value’ of that stock resides in the terminal value – something that is barely discussed and rarely features in a stock research report. We can partly mitigate for this by making sure we use very conservative assumptions for the terminal inputs.
But is this enough? If we simply stop with the above, we are perhaps failing to challenge our thinking on how likely it is that a company can navigate its unpredictable future. That is, will it be able to support what today might seem like conservative long-term profitability assumptions, or indeed, will it even be in business in the future. This is difficult to do, but if we don’t consider this, we really are sticking our heads in the sand and hoping for the best
Looking through the G&S lens
Given our insight about terminal value, arrived at in the knowledge that the future is opaque, it surely pays to test our thinking by looking through more than one lens.
By supplementing traditional financial and business analysis with a consideration of other factors that may impinge upon business sustainability – coupled with tests for whether the right conditions prevail in a company to handle these – we can arrive at more rounded conclusions about the attractiveness of a company and its stock.
This is where governance and sustainability (or ‘G&S’) analysis comes in. The issues addressed in this work are largely irrelevant for momentum investment strategies and in most cases are unlikely to impact a company’s near-term business outcomes (the front end of the explicit forecast period above), but they can have profound implications for the ability of a company to thrive in the future.
When it comes to active long-term investing, where a genuine effort is being made to compound returns for investors over extended time horizons, there are imbedded assumptions about governance and sustainability that implicitly feature in the fade window and terminal value components of firm value. These call for deeper and more careful thought. The tobacco industry provides a good example of this and, below, we shed further light by looking at Indian cigarette market leader ITC Limited.
Applying Martin Currie's Intrinsic value model
With an unleveraged return on equity over 20%, ITC Limited appears to be a good business and, with its prospective price/ earnings ratio (p/e) and price/book ratio (p/b) both over one standard deviation below their respective 10-year averages, investors may consider whether the stock is now attractively valued.
There are several potential reasons for this valuation divergence, including regulatory uncertainty, concerns of a worsening tax regime and increasing activism/outright bans from asset owners preventing investment in so-called ‘sin stocks.’ These are all very much governance and sustainability (G&S) issues.
For a different perspective on valuation, we can use the Martin Currie intrinsic value model to test what assumptions about future growth, margins and capital intensity are required to justify the current share price. Using this framework, we see that these assumptions – which initially appear reasonable – need to hold true for many years, with terminal value (present value of cash flows generated after the 15th year) accounting for over 50% of the total firm value.
Figure 3. Cash flow projections, ITC Limited
Source: Martin Currie and Factset. As at December 2019.
This insight on ITC’s valuation accentuates the importance of the G&S issues identified above, as some of these could impact future cash flows and there does not appear to be much margin for error at the current share price. They matter because in ITC’s case, as a listed company and market leader, a review of historic government behaviour suggests the company has borne a disproportionate share of the industry’s tax. For example, via significantly higher taxation and regulatory standards being applied to industrially produced cigarettes (ITC products) versus the low tax and regulation applied to the handmade beedis and smokeless tobacco (non-ITC products) that represent the overwhelming majority of the legal tobacco market in India.
A potential investor needs to be aware of these G&S issues and should try to quantify the financial impact they might have. Substantiating their potential economic impact will help us draw conclusions about the stock’s potential risk/reward as a standalone investment and enables comparison with other investment opportunities.
For instance, we can use information about the costs of tobacco to Indian society to calculate various scenarios within the framework of our intrinsic value model – e.g. pro-rating tobacco-related healthcare costs to ITC based on its market share, or deducting tobacco excise duty already applied from the direct cost of medical care for tobacco-related illnesses and netting the balance off against the company’s profits. Ultimately, regardless of how we choose to calculate or apply such a value, the point is that it is possible to evaluate G&S matters in a tangible manner.
Understanding the risk of ownership
A sensible framework for the consideration of governance and sustainability factors allows us to extract additional insights that complement and enhance the work done on firm value, to reach a more deeply informed understanding of the risk of ownership.
In investing we cannot avoid risk, but by weaving together analyses of intrinsic value, governance and sustainability, we can more readily appreciate two sets of risk that are naturally encountered in owning stocks and building portfolios – systematic risk (i.e. those risks that are inherent features of the system) and idiosyncratic risk (i.e. risks unique to a stock, which can have a bearing on future cash flows).
A well-constructed portfolio can diversify away a significant amount of idiosyncratic risk, while effective consideration of G&S factors can help identify companies that navigate systematic risks more capably, resulting in a lower cost of cost of capital and a greater market value for their stocks. Characteristics typical of such companies include robust governance procedures and strong compliance standards, strategic planning and appropriate compensation policies, as well as forward-thinking approaches to identifying and understanding how operations affect and interact with key external stakeholder interests. These companies may navigate the future more effectively and be less exposed to serious tail risk, while being better positioned to deal with unforeseen systemic shocks.
Conclusion - Being more than better informed
There is real economic value in thinking in these terms because investors will ultimately reflect systematic risk considerations into required rates of return as compensation for risk of ownership.
In discounted cash flow terms, this is captured in the cost of capital (via beta, where less systematic risk should mean a lower beta, which in turn lowers the company-specific equity risk premium) used to calculate the present value of future cash flows.
Explicitly thinking about governance and sustainability also refocuses analysis back ‘upstream’ to the high-level determinants of future business success and acts as a ballast against the natural draw of the stock market toward a focus on near-term earnings. In the end, we return better informed of risk, having viewed a company through different lenses, to our original endeavour: consideration of the value of future cash flows – i.e. those captured in the explicit forecast period, the fade window and, yes, the terminal value.
However, it doesn’t end there. Aiming to be truly effective in our stewardship of client capital and embracing the mindset that we are buying ownership stakes in businesses, we take this deeper understanding into our engagements with the companies in which we invest. By encouraging portfolio companies to adopt better governance practices, to embrace strategic planning that specifically incorporates key sustainability issues, and to identify and appropriately manage broader stakeholder interests, we believe we can positively influence the navigability of systematic risk leading to enhanced shareholder value in the future.
Aiming to be truly effective in our stewardship of client capital and embracing the mindset that we are buying ownership stakes in businesses, we take this deeper understanding into our engagements with the companies in which we invest.
Past performance is not a guide to future returns.
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Investment Management Limited (‘MCIM’), authorised and regulated by the Financial Conduct Authority. It does not
constitute investment advice.
The analysis of Environmental, Social and Governance (ESG) factors form an important part of the investment process and helps inform investment decisions. The strategy does not necessarily target particular sustainability outcomes.
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