An Investor’s Perspective
I came across the term “sustainability” while studying finance in contexts like sustainable debt (the ability to meet debt obligations) and sustainable income (profit earned after expenses at a steady rate over time). According to the Oxford Dictionary, “sustainable” means “capable of being endured” or “capable of being maintained or continued at a certain rate or level,” and it often refers to forms of human activity that minimize environmental degradation. We have recently started to associate sustainability in finance more closely with the latest definition, particularly regarding environmental, social, and governance (ESG) issues.
Conversely, “value” relates to the “importance, worth, or usefulness of something, and its beneficial nature.” Therefore, when we aim to create value sustainably, we need to create something meaningful, worthy, and beneficial that can endure over time without causing significant harm. As a society, we can create sustainable value by considering economic, financial, and strategic variables alongside social and environmental ones.
In finance, a sustainability approach to value creation could translate into higher income and greater returns -after adjusting for risk- for investors in the long run. I outline how you can adopt an ESG investment approach below.
You as an Investor
Imagine you are buying stocks. You sign in to your broker account and look at the hottest companies’ prices (we all start there): Amazon at $177, Microsoft at $417, and Nvidia at $1,120. These prices seem very high, even inflated. But how do you know if these prices are high or low? What are your expectations, and why? What are the risks?
First, remember that stocks are risky because you can lose your entire investment if the company goes bankrupt. However, if the company performs well, the stock price can increase significantly—potentially far beyond your initial investment. Thus, knowing everything about the company is crucial to make an informed decision.
Value vs. Price
When picking a stock, it’s essential to determine if the stock price truly reflects the company’s value. In finance, various methodologies exist for valuing a company. Let’s simplify this by discussing a standard valuation method called Discounted Cash Flow (DCF). DCF is based on projecting a company’s financial data over a chosen period. This method allows you to quantitatively assess whether the present value of these projections aligns with the current market price.
If your valuation is higher than the current price, it indicates potential value creation. However, it’s crucial to understand the assumptions behind these projections—how realistic and ambitious the numbers are, the company’s strategy, and how it will execute that strategy.
“You don’t get a quick return creating value for the world. You get a quick return doing something that doesn’t matter. But if you are going to make a difference in society, changing the world for the better, you better be prepared for a long journey. ”
Ed Zschau
ESG Approach
You want to adopt an ESG approach in your investment decisions (and your valuation!) because social and environmental factors affect the risk and return of the investment. Therefore, it is essential to know if the company integrates ESG factors into its strategy and how it does so. Start with the company’s sustainability report and check if they identify financial and non-financial risks and opportunities and how those could affect financial performance. Companies will use the recent International Financial Reporting Standards (IFRS) for standardized information disclosure for sustainability information (S1, S2).
You should find this information on the company’s website, including interviews and reports that clearly explain how the company is creating value over time. At this point, some questions arise: The report looks good on paper, but are they genuinely integrating sustainability into their strategy? Are they launching new products with sustainability features? Are they considering changes in demand preferences for environmentally friendly products? Are they building new factories with energy and water efficiencies, and is this changing their operating expenses? Are they financing capital expenditures with sustainability bonds or green loans?
Strategy and Sustainability: The Story Behind the Numbers
“Excel can bear anything.”
As an investor, you need to understand the problem the company is trying to solve. What is its purpose? What solutions are it proposing, and how is it reaching the population it wants to impact? How is the company creating value for its investors? Is it also creating value internally for employees, suppliers, communities, and the environment?
“You cannot have a sustainable business model if the people themselves aren’t living sustainable lives.”
Paul Polman
Some companies only comply with regulation. However, compliance with regulations is the minimum requirement for a company to operate. Compliance does not mean value creation, but non-compliance means value destruction.
Under the ESG approach, sustainability is expected to be embedded in the core of the company’s strategy, purpose, and operational plans. While companies may set targets and enhance their ESG performance, they frequently struggle to convert these improvements into financial outcomes. To solve this, New York University developed a framework to calculate the sustainability return called Return on Sustainability Investment (ROSI) to help measure the value that firms create by adopting sustainability practices. ROSI can be helpful in your investment analysis.
Furthermore, for a company’s sustainability strategy to succeed, it needs a strong leadership team with clear rules, processes, and directions. Good corporate governance is essential for executing a sustainability strategy.
Risk Management
“If Excel can handle anything, strategy on paper never refuses ink.”
An Excel spreadsheet and a strategy could be just aether. That’s why, as an investor, you must understand the company’s track record, valuation model assumptions, operating geographies, macroeconomic outlook, industry trends, competitive advantages, business models, long-term plans, and risks.
Risk management should be a constant focus. All decisions have an upside and a downside: it is ideal to identify all potential risks, including operational (suppliers), financial (liquidity, interest rates), and strategic (reputational, regulatory).
ESG has recently become a top risk classification due to the significant impacts that social and environmental issues can have on companies and vice versa. The firm should use scenario analysis to quantify the financial impact of climate risks (which will soon be mandatory in many countries). The IFRS S1 and S2, as well as the ROSI framework, are helpful for risk assessment. Climate Value at Risk (CVaR) is another tool to assess climate-related risks within an investment portfolio. CVaR calculates the maximum value a portfolio of assets may lose due to climate risks.
Ready to invest?
There are different dimensions to consider when creating value. Sustainability is one that investors and companies are increasingly considering in their decision-making processes—some because of regulation, others as part of a strategic position. When evaluating investment returns, it is beneficial to adopt an ESG approach in both personal and professional financial decisions.
What’s the value you are creating today?
À bientôt
