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BE352 - Financial Reporting/Markets > L6-7: ESG and Corporate Valuation > Flashcards

L6-7: ESG and Corporate Valuation Flashcards

1
Q

When talking about ESG, it can mean different things, like…

A
  • ESG investing
  • ESG performance
  • ESG reporting
    → We can take different perspectives.
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2
Q

What are some approximate terms for ESG?

A
  • Corporate social responsibility (CSR) - does not include governance
  • Sustainability
  • Stakeholder orientation
  • Socially responsible investing (SRI)
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3
Q

What is the impact of ESG on corporate valuation?

A

Unclear!

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4
Q

Why do firms engage in Environmental and Social activities?

A

Various sources of pressure have arisen over time to encourage ESG:
- Money flowing into sustainable investment funds
- Shareholders sponsoring ESG-related proxy proposals
- Institutional investor activism (BlackRock, Vanguard, State Street)
- Ratings, indices, and lists
- Employee activism
- Third-party activism and NGOs

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5
Q

What are stakeholders?

A

All constituents with a direct or indirect interest in the corporation, like: customers, suppliers, employees, creditors, trade unions, local communities, and local governments.

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6
Q

What are 7 examples of stakeholder interests?

A
  • sustainability
  • reduction in waste or pollution
  • higher wages
  • workplace equality
  • diversity
  • affordability and access to products
  • being a responsible counterparty or local citizen
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7
Q

What stakeholder interests do we generally refer to?

A

The most directly relevant issues for each firm - materiality!

Because companies operate in different industries, stakeholder interests vary across corporations.

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8
Q

What does a materiality matrix look like?

A

Axis 1: impact on financial/company performance

Axis 2: Stakeholder importance.

Along a 45 degree line, the materiality increases

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9
Q

How much do firms invest in ES activities?

A

Corporate donations: proxy for ES activities. Have been increasing significantly for all channels.
- In the US in 2014, companies donated around $18 billion.
- Other reports provide similar estimates. Fortune Global firms spend around $20 billion a year on CSR activities.

More than 90% of the 250 largest companies in the world now produce annual CSR reports (these are not audited!), even though it implies a cost/investment.

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10
Q

What are the 8 different SRI investment styles?

A
  • Engagement / active ownership
  • Full integration
  • Negative screening
  • Positive screening
  • Relative / best-in-class screening
  • Overlay / portfolio tilt
  • Thematic investment
  • Risk factor / risk premium investing
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11
Q

What is engagement/active ownership SRI investment?

A

The use of shareholder power to influence corporate behavior through direct corporate engagement (communicating with senior management and/or boards), filing or co-filing shareholder proposals, and proxy voting that is directed by ESG guidelines.

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12
Q

What is full integration SRI investment?

A

Explicit inclusion of ESG factors into traditional financial analysis of individual stocks (e.g. as inputs into cash flow forecasts and/or cost-of-capital estimates).

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13
Q

What is negative screening SRI investment?

A

The exclusion of certain sectors, companies, or practices from a fund or portfolio on the basis of specific ESG criteria.

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14
Q

What is positive screening SRI investment?

A

The inclusion of certain sectors, companies, or practices in a fund or portfolio on the basis of specific minimum ESG criteria.

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15
Q

What is relative/best-in-class screening SRI investment?

A

The investment in sectors, companies, or projects selected for ESG performance relative to industry peers.

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16
Q

What is overlay/portfolio tilt SRI investment?

A

The use of certain investment strategies or products to change specific aggregate ESG characteristics of a fund or investment portfolio to a desired level (e.g. tilting an investment portfolio toward a desired carbon footprint).

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17
Q

What is thematic investment?

A

Investment in themes or assets specifically related to ESG factors, such as clean energy, green technology, or sustainable agriculture.

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18
Q

What is risk factor / risk premium investing?

A

The inclusion of ESG information in the analysis of systematic risks as, for example, in smart beta and factor investment strategies (similar to size, value, momentum, and growth strategies).

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19
Q

What is the legal case on Shareholder vs. Stakeholder view?

A

Early 1930’s: debate on the purpose of the corporation.

  • Berle - Shareholder view: The management of a corporation should be held accountable only to shareholders for their actions (don’t internalize negative externalities).
  • Dodd - Stakeholder view: corporations were accountable to both the society in which they operated and their shareholders.

→ Legally, managers should optimize shareholder value, since the cause-effect relationship of negative externalities in unclear/indirect.

Milton Friedman (1970): “The social responsibility of business is to increase its profits”. The debate is still ongoing.

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20
Q

What can we say about the ExxonMobil Oil Spill?

A

Easy to connect the cause and the consequences of the environmental risks. Sources say most expensive oil spill in history, and amounts could be quantified (like cleanup costs).

→ We can directly assess the responsibility of ExxonMobil.

But in most cases: not as clear which issues companies should internalize.

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21
Q

What is the Dodge vs. Ford Motor case (1919)?

A

Lawsuit by shareholders (derivative). Ford lowered price of cars, wanted to employ more, spread benefits to the greatest number of people possible, by reinvesting profits in company.

Court said he had to operate in the interest of shareholders, rather than in a charitable manner for the benefit of his employees or customers. This led to the shareholder supremacy doctrine, i.e. corporate directors must maximize shareholder value.

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22
Q

What is the Shlensky vs Wrigley case (1968)?

A

About installation of lights for night baseball. Owner of club did not want to, worried it would disturb surrounding neighbourhood. Other argued they were losing money by not playing at night, should be concerned with shareholders instead of neighbourhood.

Court dismissed: decisions should not be disturbed just because a policy chosen by the company may not be the wisest policy available (business judgment rule)

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23
Q

What is the shareholder supremacy doctrine?

A

Corporate directors must maximise shareholder value

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24
Q

What is the business judgment rule?

A

Managers’ decisions are protected

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25
Q

What can be used to find similar material ESG issues within an industry?

A

SASB standards: industry specific.

Companies operating in a specific industry are more likely than companies in disparate industries to have similar business models and use resources in similar ways. Hence, they are likely to have similar sustainability risks and opportunities.

26
Q

What is the connection between material ES issues and shareholder value?

A

Regressions to measure alpha.

Firms with high ESG investments tend to have higher alphas, but not robust evidence, since not consistent for groups. The significance becomes greater when only looking at material issues.

The effect on net margin:
- All sustainability issues: only statistically different after 5 years.
- Material issues: statistically different from near future to the end.

27
Q

What happens to alpha on the day of an ES vote in a company?

A

regression discontinuity –> gap. Implies investors react positively, possibly because resolutions are shareholder proposed

28
Q

What can we say about the link between ES engagement and financial performance?

A
  • No clear answer as to whether engagement in ES activities leads to superior financial performance.
  • Negative association between CSR and cost of capital and idiosyncratic risk.
  • Investors respond strongly negatively to negative CSR events and weakly negatively to positive (voluntary) CSR events. Financial analysts also downgrade their estimates in the short- and long-run due to negative ESG news.
29
Q

What does the investor case (SRI) tell us?

A

Case targeted managers of non-ESG funds. Some ESG info still taken into account because of MATERIALITY.

The greatest reason for not including it is lack of stakeholder interest. Lack of comparability across firms (and cost) also limit the ability to integrate ESG in decision making

30
Q

Does ESG disclosure impact CAR?

A

CAR = cumulative abnormal returns.

Yes, it is statistically significant. However: Disclosure only indicates reporting, not actual investments in ESG

31
Q

How can mandatory ESG reporting facilitate investments?

A

If you have to report, you want to improve –> investments.

(shortcuts possible, cut male wages instead of increasing female to close wage gap)

32
Q

How can the impact of ESG factors and financial factors on company valuation be indicated?

A

By adjusting:
- Future sales growth sales
- Future OPEX
- Forecast horizon
- Terminal value
- Beta or discount rates

33
Q

How can Sales be adjusted for ESG?

A

ESG factors can be integrated into these forecasts by increasing or decreasing the company’s sales’ growth rate by an amount that reflects the level of investment opportunities or risks.

34
Q

How can OPEX be adjusted for ESG?

A
  • Make assumptions about the influence of ESG factors on future operating costs and either adjust them directly or adjust the EBIT margin.
  • Some operating costs may be forecasted explicitly, but depending on the level of disclosure by companies, it may be necessary to make adjustments to the operating margin instead.
  • Example: future OPEX may be reduced due to a variety of initiatives that will reduce the company’s energy consumption and reliance on fossil fuels.
35
Q

How can the forecast horizon be adjusted for ESG?

A

ESG investments tend to be long-term, so a longer forecast period may be necessary to capture the investment dynamics and not be subsumed by the steady-state assumptions.

36
Q

How can terminal value be adjusted for ESG?

A
  • ESG factors could cause beliefs that a company or its business line will not exist forever. Then, the terminal value may be reduced to a lower value or to zero.
  • Alternatively, the assumptions about the steady state might be adjusted to reflect an ESG premium.
37
Q

How can beta or discount rate be adjusted for ESG?

A
  • Adjusting in valuation models to reflect ESG factors is ideal when there is an apparent ESG risk to the company.
  • One approach: run a peer analysis of companies within the sector and then rank them by an ESG factor. Then the beta/discount rate can be increased/decreased for companies considered to possess high/low ESG risk, in turn reducing/increasing the fair value.
38
Q

What does corporate governance deal with?

A

The ways in which suppliers of finance to corporations assure themselves of getting a return on their investment.
- How do they get managers to return some of the profits to them?
- Make sure managers don’t steal the capital or invest it in bad projects?
- How do they control managers?

39
Q

How could Health Corp. artificially inflate financial results and CEO benefit from it?

A

What was the board of directors doing?
- Compensation committee met only once during 2001.
- Forbes 2022: the CEO has “provided sub-par returns to shareholders while earning huge sums for himself”. Still not fired by the BoD.

What was the external auditor (E&Y) doing?
- The Audit committee met only once during 2001.
- The President and CFO were previously auditors for E&Y.
- Audit fee of $1.2 million vs. other fees of $2.5 million.

What were the analysts doing?
- UBS analyst had a “strong buy” on HealthSouth.
- UBS advised HealthSouth on more than $2 billion in financings over the past 2 years leading up to the scandal, receiving about $7 million in fees.

40
Q

What is backdating?

A

Ex. Receiving stock options dated at low points in the company’s stock price

41
Q

What is related to Executives maximize their own utility vs. maximizing shareholders’ value?

A
  • The owners of the company are separate from the management of the company (separation of ownership and control).
  • Agency problem: management takes self-interested actions that are not in the interest of shareholders.
  • Agency costs: shareholders bear the cost of these actions.
42
Q

What are some examples of agency problem?

A
  • Insufficient time and effort on building shareholder value
  • Inflated compensation or excessive perquisites
  • Manipulating financial results to increase bonus or stock price
  • Excessive risk taking to increase short-term results and bonus
  • Failure to groom successors so management is “indispensable”
  • Pursuing negative-NPV acquisitions to “grow the empire”
  • Thwarting hostile takeover to protect job
43
Q

Is there a One-size fits all solution for governance?

A

No, fails despite measures like:
- Majority of independent directors and independent audit committee
- Enhanced penalties for misrepresentations
- Shareholder approve of executive pay
- High governance ratings

44
Q

What is the dual mandate of boards of directors?

A
  • Advisory: consult with management regarding strategic and operational direction of the company.
  • Oversight: monitor company performance and reduce agency costs.

Effective boards satisfy both functions. The responsibilities of the board are separate and distinct from those of management. The board does not manage the company.

45
Q

What are responsibilities of boards?

A
  1. Approve the corporate strategy
  2. Test business model and identify key performance measures
  3. Identify risk areas and oversee risk management
  4. Plan for and select new executives
  5. Design executive compensation packages
  6. Ensure the integrity of published financial statements
  7. Approve major asset purchases
  8. Protect company assets and reputation
  9. Represent the interest of shareholder
  10. Ensure the company complies with laws and codes
  11. Review culture and “tone from the top”
46
Q

What is board independence?

A

Boards are expected to be independent:
- Act solely in the interest of the firm
- Free from conflicts that compromise judgment
- Able to take positions in opposition to management

Independence is defined according to regulatory standards. However, independence standards may not be correlated with true independence. It requires a careful evaluation of the board member’s biography, experience, previous behavior, and relation to management.

47
Q

How does a board operate?

A
  • Presided over by chairperson: sets agenda, schedules meetings, coordinates actions of committees.
  • Decisions made by majority rule.
  • To inform decisions, the board relies on materials prepared by management, but they can ask for more information.
  • Periodically, independent directors meet outside the presence of management (executive sessions).
48
Q

What are board committees?

A
  • Not all matters are deliberated by the full board. Some are delegated to subcommittees.
  • Committees may be standing or ad hoc, depending on the issue at hand.
  • All boards are required to have audit, compensation, and nominating committees.
  • On important matters, the recommendations of the committee are brought before the board for a vote.
49
Q

What can be responsibilities of an audit committee?

A
  • Oversight of financial reporting and disclosure
  • Monitor the choice of accounting policies
  • Oversight of external auditor
  • Oversight of regulatory compliance
  • Monitor internal control processes
  • Oversight of performance of internal audit function
  • Discuss risk management policies
  • Requirements of at least 1 financial expert on the audit committee
50
Q

What are the two main election regimes for director of the board?

A
  • Annual election: directors are elected to one-year terms.
  • Staggered board: directors are elected to three-year terms, with one-third of the board standing for election each year.

Staggered boards are an effective antitakeover protection, and may also insulate or entrench management.

51
Q

What three mechanisms are Director liability is reduced by?

A
  1. Exculpatory provision: company charter excuses director from liability for unintentionally negligent acts.
  2. Indemnification: agreement that company will pay for costs associated with lawsuits (if the director acted in “good faith”).
  3. Director and officers insurance (D&O): insurance contract that covers litigation expenses, settlement payments, and in some cases damages.

Conclusion: out-of-pocket payments by directors are very rare.

52
Q

Why do companies have external auditors?

A

Accurate financial reporting is critical for the efficiency of capital markets and the proper valuation of securities.
- Allows board and investors to make informed evaluation of strategy, business model, and risk.
- Allows board to structure compensation appropriately and award performance-based compensation knowing that predetermined targets were met.

It is the role of the audit committee to ensure the accuracy of reports.
- Sets parameters for quality, transparency, and controls.
- Hires external auditor to test for misstatement.

53
Q

What guidelines does the audit committee establishes to dictate the quality of accounting used in the firm?

A
  • Quality: the degree to which accounting figures precisely reflect changes in financial position, earnings, and cash flows.
  • Transparency: the degree to which the company provides details that supplement and explain accounts reported in statements and filings.
  • Internal controls: the processes and procedures that ensure transactions are accurately recorded, financial statements reliably produced, and company assets protected from theft.
54
Q

Evidence suggest that companies are not as effective as they believe in preventing accounting quality abuse, like…

A
  • Much less likely to report a small decrease in earnings than a small increase.
  • Managers make small manipulations in accounts so that net income figures are rounded up rather than down.
  • Companies that beat earnings with “low-quality” earnings have better short-term but worse long-term performance.
  • In any given period, about 20% of firms manage earnings (to meet analyst forecasts). Among them, the average level of earnings management is 10% of sales.
55
Q

What is the objective of external auditing?

A

Assess the validity and reliability of publicly reported financial information. Shareholders expect an objective third party to provide assurance that the information is accurate.

  • Despite public expectations, it is not the explicit objective of the audit to identify fraud.
  • Instead, the objective is to express an opinion on whether statements comply with accounting standards. Auditors express an “unqualified opinion” if it finds no reason for concern.
56
Q

How can the market work for corporate control?

A

Price of a stock also reflects performance of management in realizing corporate value. The board of an underperforming company has the choice:
- Replace management, or
- Sell the entire company to new owners who can manage its assets more profitability (e.g. change strategy, cost structure, capital structure, etc).

The market for corporate control puts pressure on the CEO to perform or risk sale of the company.

57
Q

What does the market for corporate control consist of?

A

All mergers, acquisitions, and reorganizations - including those by a competitor, a conglomerate, or a private equity buyer.

58
Q

What is a friendly acquisition?

A

When the target is open to receiving an offer. Otherwise it is hostile.

59
Q

What is a tender offer?

A

The acquirer makes an offer directly to the target shareholders to purchase their shares at a stated price.

60
Q

What is a proxy contest?

A

The acquirer asks target shareholders to elect a dissident slate of directors to approve the deal.

BE352 - Financial Reporting/Markets (6 decks)

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