P3 Chp 9 Integrating ESG Beyond DCF

Question 1

Applied at the enterprise or project level, _____ ____ _____ _____ serves as an efficiency measure that tells the user how well the company is utilizing capital to generate profits. In other words, it measures how well a company creates value with the capital that shareholders (or other investors) provide to the firm.

Answer 1

Applied at the enterprise or project level, return on invested capital serves as an efficiency measure that tells the user how well the company is utilizing capital to generate profits. In other words, it measures how well a company creates value with the capital that shareholders (or other investors) provide to the firm.

Question 2

Through the ROIC formula, a user can understand how sustainability can influence _____ and ______ returns at the company level through one or more core channels of financial impact.

Answer 2

Through the ROIC formula, a user can understand how sustainability can influence current and expected returns at the company level through one or more core channels of financial impact.

Question 3

Where net operating profits _______ capital expended, the company earns a return on capital invested for the project.

Answer 3

Where net operating profits exceed capital expended, the company earns a return on capital invested for the project.

Question 4

Users can leverage analysis using ROIC to understand if, and by how much, a company may have a _______ _________. To do so, consider two key questions:
1. Does ROIC exceed cost of capital?
2.Is a company’s ROIC higher than its peers?

Answer 4

Users can leverage analysis using ROIC to understand if, and by how much, a company may have a competitive advantage.

Question 5

A ______ ________ exists where customers habitually use a product or face high costs of searching for and switching to a new product.

Answer 5

A consumer advantage exists where customers habitually use a product or face high costs of searching for and switching to a new product.

Question 6

A _____ ________ exists where a company spends less to deliver its goods or services than its competitors, either due to advantageous access to inputs or to proprietary technology that cannot easily be imitated.

Answer 6

A production advantage exists where a company spends less to deliver its goods or services than its competitors, either due to advantageous access to inputs or to proprietary technology that cannot easily be imitated.

Question 7

If sustainability information leads to an adjustment that improves ROIC through operating margin (via improved profitability), a user may consider that as a signal that the company is managing sustainability performance to gain a ________ advantage and focus their analysis accordingly.

Answer 7

If sustainability information leads to an adjustment that improves ROIC through operating margin (via improved profitability), a user may consider that as a signal that the company is managing sustainability performance to gain a consumer advantage and focus their analysis accordingly.

Question 8

If sustainability information leads to an adjustment that improves ROIC through ______ ______ (higher sales relative to invested capital), a user can consider that as a signal that the company may be managing sustainability performance to gain a _______ advantage, and focus engagement and further analysis accordingly.

Answer 8

If sustainability information leads to an adjustment that improves ROIC through turnover ratio (higher sales relative to invested capital), a user can consider that as a signal that the company may be managing sustainability performance to gain a production advantage, and focus engagement and further analysis accordingly.

Question 9

The following are example metrics of what?

• Revenue from products third-party certified to environmental or social sustainability sourcing standards: This metric lends insight into cash inflows related to a company’s ability to capture demand for products with sustainability attributes.
• Revenue from products designed for use-phase resource efficiency: This metric captures cash inflows related to a company’s ability to capture demand for products with sustainability attributes.
• Marketing and recruiting practices: This metric captures the extent to which companies may be misleading potential customers through marketing or practicing aggressive recruiting practices, which, depending on the company’s management of the issue, may
  represent reputational risk.

Answer 9

Consumer Advantage

Question 10

The following metrics are examples of what?

• Percentage of (1) Tier 1 supplier facilities and (2) supplier facilities beyond Tier 1 that have completed the Sustainable Apparel Coalition’s Higg Facility Environmental Module (Higg FEM) assessment or an equivalent environmental data assessment: This metric can lend insight into the extent that a company has secured relationships with suppliers that reliably provide products that meet sustainability performance requirements, thus contributing to the sustainability attributes of clothing products.
• Weight of end-of-life products and e-waste recovered, percentage recycled: This metric
  lends insight into the extent to which a company may simultaneously achieve cost reductions through reduced waste (as e-waste disposal is often costly) and the extent to which risks related to the supply of key inputs such as precious metals and other materials can be mitigated.

Answer 10

Production Advantage

Question 11

The following are questions for analysis of what?

Does performance on one or more ESG factors influence earned revenues, thereby warranted adjustments to sub-components of operating profit forecast (NOPAT and/or sales)?
* Does performance on one or more ESG factors impact assets and/or liabilities, warranting adjustment to net working capital forecast (a sub-component of
invested capital)?

Answer 11

USING ROIC TO ASSESS SOURCES OF COMPETITIVE ADVANTAGE

Question 12

In fundamental analysis, users may also assess a company’s ability to create value using _____ ______ _______, also called economic profit.

Answer 12

In fundamental analysis, users may also assess a company’s ability to create value using economic value added (EVA), also called economic profit.

Question 13

The same core channels of financial impact that can influence WACC (cost of equity and debt) and ROIC (revenues, assets, and liabilities) can also inform analysis using _____ (acronym)

Answer 13

The same core channels of financial impact that can influence WACC (cost of equity and debt) and ROIC (revenues, assets, and liabilities) can also inform analysis using EVA

Question 14

EVA can be used as a management tool for attributing performance to _____ ______ or ______
______ within a company, as its focus on invested capital means it measures the value created by management for shareholders.

Answer 14

EVA can be used as a management tool for attributing performance to specific projects or strategic actions within a company, as its focus on invested capital means it measures the value created by management for shareholders.

Question 15

Sustainability issues are often _______ _________. The issues that affect business performance today will likely change in the near, medium, and long term. Indeed, the likelihood, timing, and magnitude of financial impacts from sustainability factors typically do not remain constant over time.

Answer 15

Sustainability issues are often dynamically material. The issues that affect business performance today will likely change in the near, medium, and long term. Indeed, the likelihood, timing, and magnitude of financial impacts from sustainability factors typically do not remain constant over time.

Question 16

Sustainability impacts are ________ . Performance on one ESG factor is often tied to more than one other business function and performance factor, requiring a level of integrated thinking to clearly understand how
sustainability factors create or erode company value.

Answer 16

Sustainability impacts are interrelated. Performance on one ESG factor
is often tied to more than one other business function and performance
factor, requiring a level of integrated thinking to clearly understand how
sustainability factors create or erode company value.

Question 17

Effective _______ ________ helps companies and investors anticipate outcomes, rather than simply react to events, to guide capital allocation decisions and, potentially, improve risk-adjusted returns, among other benefits. _______ _______ can also serve as an exercise in stress testing, or simulating future adverse ______ to understand how the organization may fare. In other words, it helps users assess the magnitude of risks and evaluate the adequacy of assets.

Answer 17

Effective scenario analysis helps companies and investors anticipate outcomes, rather than simply react to events, to guide capital allocation decisions and, potentially, improve risk-adjusted returns, among other benefits. Scenario analysis can also serve as an exercise in stress testing, or simulating future adverse scenarios to understand how the organization may fare. In other words, it helps users assess the magnitude of risks and evaluate the adequacy of assets

Question 18

_______ _________ are used to describe a set of possible future states and test a range of options within the context of those future states. For example, a scenario in which global sea level rises 0.38 meters (or 1.24 feet) by 2050.56 Outcomes include informed strategic decisions within the context of possible future states of business.

Answer 18

Exploratory scenarios are used to describe a set of possible future states and test a range of options within the context of those future states. For example, a scenario in which global sea level rises 0.38 meters (or 1.24 feet) by 2050.56 Outcomes include informed strategic decisions within the context of possible future states of business.

Question 19

______ _______ are used to plan for a specific performance target or preferred future outcome. For example, a scenario in which a company reaches net-zero emissions by a specific year. Outcomes include informed decisions needed to reach a specific goal.

Answer 19

Normative scenarios are used to plan for a specific performance target or preferred future outcome. For example, a scenario in which a company reaches net-zero emissions by a specific year. Outcomes include informed decisions needed to reach a specific goal.

Question 20

Describe the best case, base case and worst case

Answer 20

1. Best case: the ideal scenario (i.e., the combination of assumptions that leads
   to the best upside financial outcomes)
2. Base case: the average scenario (i.e., the combination of assumptions the company is most likely to experience without significant changes to its current trajectory)
3. Worst case: the most severe negative outcome that could feasibly happen (i.e., the combination of assumptions that leads to the worst downside financial outcomes)

Question 21

Whether estimating a company’s _____ value, assessing profitability and ability to increase investment returns over time, understanding sources of _____ ______, or informing strategic decisions via ______ _______, SASB data can inform key variables to foster a more complete and accurate understanding of the sustainability issues that create, protect, or erode
enterprise value.

Answer 21

Whether estimating a company’s intrinsic value, assessing profitability and ability to increase investment returns over time, understanding sources of competitive advantage, or informing strategic decisions via scenario analysis, SASB data can inform key variables to foster a more complete and accurate understanding of the sustainability issues that create, protect, or erode
enterprise value.

Question 22

[CHECK FOR UNDERSTANDING] How can ESG information lend insight into a company’s ability to drive investment returns?

Answer 22

To evaluate if ESG performance contributes to a company’s ability to drive investment returns, users must determine if the value generated by the company’s management of the issue exceeds its associated costs. To do this, users can apply the channels of financial impact associated with performance on a sustainability issue to financial tools and formulas used to calculate investment returns. Return on invested capital (ROIC) is one tool for valuation that helps to illustrate this logic. All else equal, ROIC improves where ESG performance contributes to increased profitability relative to total invested capital. Where ROIC is greater than a company’s cost of capital, users can generally conclude that the company is creating value.

To calculate ROIC, and thus to understand if and to what extent sustainability performance drives returns, users must connect the core channels of financial impact to the variables within the ROIC formula. Specifically, users must consider: operating profit (i.e. revenues minus expenses), sales, total invested capital, and weighted average cost of capital. Where performance on an ESG metric is linked to these variables via revenues, expenses, assets, liabilities, or cost of capital, a user can interpret the relative effects on investment returns accordingly (see Section
9.1.)

Question 23

[CHECK FOR UNDERSTANDING] What variables, informed by ESG information, can lend insight to the source of companies’ competitive advantage?

Answer 23

The same variables that lend insight into a company’s ability to drive returns through ESG performance can lend insight into the source of that company’s competitive advantage, namely operating profit, sales, and invested capital. If sustainability information leads to an adjustment that improves ROIC through operating profit (greater revenues or reduced expenses), a user may consider that as a signal that the company is managing sustainability performance to gain a consumer advantage and focus their analysis accordingly. If sustainability information leads to an adjustment that improves ROIC through turnover ratio (higher sales revenue relative to invested capital), a user can consider that as a
signal that the company may be managing sustainability performance to gain a productionadvantage, and focus engagement and further analysis accordingly
(see Section 9.1.1.).

Question 24

[CHECK FOR UNDERSTANDING] How does EVA lend insight into the efficacy of corporate management decisions?

Answer 24

Economic value added (EVA) is a formula companies often use to assess profitability. If EVA is positive, the company is generating value from the funds invested in the business. The opposite is true when EVA is negative. The EVA formula considers the capital needed to produce earnings, either at the enterprise or project level. This allows corporate managers and investors to attribute returns to specific decisions about how a company is deploying capital and managing resources. Consider the example in Section 9.1.2., where the company invested heavily in recycling infrastructure and processes, resulting in a 75 percent reduction in energy use relative to new aluminum sourcing and processing. The quantity of capital invested can be compared against the associated financial impacts of this decision to assess if the decision added economic value, namely increased revenues, increased investment expenses, decreased operating expenses, increased tangible asset value, and lower cost of capital (see Section
9.1.2.)

Question 25

[CHECK FOR UNDERSTANDING] How can information reported in alignment with the SASB Standards inform scenario analysis?

Answer 25

When conducting sustainability-informed scenario analysis, the SASB Standards can contribute at nearly every stage of analysis. Indeed, the benefits that information produced through the Standards bring to DCF are largely the same as those experienced when applying the Standards and surrounding resources to scenario analysis.
The table in Section 9.2.1. defines these benefits. In DCF-based scenario analysis, the SASB Standards help to:
1. Identify and assess material sustainability-related risks and opportunities.
2. Defined the scope of analysis and the parameters that define various scenarios.
3. Evaluate the impact of sustainability performance on financial performance
and operating results.
4. Measure performance against baselines established by modeled scenarios.
5. Inform strategic decisions and courses of actions based on results of analysis (see Section 9.2.1.).