How do ESG risks impact your company’s true value?

Environment, Social and Governance (ESG) is a framework to measure a business’s impact on environmental issues, the communities it operates in, and the people it works with and employs. While the United Nations report titled ‘Who Cares Wins’ is often credited as the first well-known mention of ESG, the idea that businesses should be held accountable for how they are run and their impact on the world has been around for ages.

More than two decades later, ESG investing is still prevalent. In fact, by the end of 2024, the assets under management (AUM) of global ESG funds quadrupled from 2018 to 2024, reaching $3.2 trillion. This continued interest in ESG investing is a testament to the framework aiding efforts to recognize viable investing opportunities instead of being a hindrance or distraction.

Hence, entrepreneurs who wish to raise funds must understand how ESG performance can affect the valuations of their businesses.

How are ESG scores calculated?

ESG scores are calculated and reported by agencies such as S&P Global and Bloomberg. While the exact methodology may differ from agency to agency, the general principles stay the same.

The agencies will break down each ESG pillar, i.e., Environment, Social, and Governance, into various issues and assign scores along a scale such as 1-10 based on their independent research. A weighted average of these issue-level scores is taken to arrive at the pillar scores.

Finally, weights are assigned to each pillar depending on the relevance of each pillar to the industry. Every industry does not have the same governance standards and the same impact on the environment and society. For instance, when we think of the environmental impact of businesses, our eyes turn to energy producers and manufacturers.

On the other hand, the role of financial institutions in bringing about financial inclusion and creating a level playing field for everyone in society cannot be discounted.

So, in ESG calculations, most agencies will assign the highest weights for Environment Scores in the case of oil and gas companies, but assign the highest weights for Social Scores in cases of financial services companies.

However, for all kinds of companies, equal importance must be placed on governance. Ultimately, a company that does not manage its own operations efficiently cannot survive in the long term. Thus, it cannot be called a sustainable business.

How does ESG performance impact company valuations?

Investor perception plays a key role in valuations and is the reason why Environmental Scores have a smaller impact on company valuations than Social and Governance Scores. The following discussion will focus on uncovering the reasons behind this phenomenon.

Impact of environmental protection regulation

In the United States, in comparison to the scale of economic activity, the fines levied on businesses for environmental protection law violations tend to be on the lower side. Between 2015 to 2023, the highest amount of administrative and civil judicial penalties in a year was $71.39 million. This figure suddenly jumped to $1.64 billion in 2024 on account of Cummins Inc. paying the second-largest environmental penalty in history.

However, the cost of court or government agency-mandated actions to reduce or fix environmental harm tends to be much higher. Since 2015, the cost of such actions has consistently stayed over $350 million every year and went over $2 billion in 2021, 2023, and 2024.

From this, we can interpret that the US government has the stance of promoting corrective actions rather than simply taking punitive actions. So, if a company has a poor Environment Score, it is likely to be mandated to take expensive corrective actions down the line. This elevated risk of negative cash flows and disruption of operations would reduce company valuations. In the worst-case scenario, such a company may face a hefty penalty, which would severely deplete cash reserves and derail operations.

Impact of Social and Governance performance

In 2022, Borsa Istanbul employees attempted to find the link between ESG performance and firm value and profitability. In their study, they tracked the ESG scores, firm values, and return on assets (ROA) of 1,750 of the largest companies by market capitalization on Bloomberg Intelligence from 2013 to 2021. They found that while all three ESG factors have a positive and significant impact on profitability, when firm value is considered, Social and Governance Scores are more relevant than Environment Scores.

Hence, we can conclude that Environment Scores can be an indication of cash flow health, but not market perception. In contrast, Social and Governance Scores impact cash flow health as well as market perception.

So, if we estimate a company’s value through the market approach as well as the income approach, we must ensure that the Environmental, Social, and Governance scores affect the income-based valuation while only the Social and Governance scores affect the market-based valuation.

How poor ESG scores impact your company’s valuation

In this section, we will explore how ESG performance can impact the valuation of the same company. To do so, we will apply the income-based and market-based approaches to find the valuation of Finnova Ventures, a financial services company. The following are the two ESG performance scenarios that we will consider.

Scenario 1

Particulars	Environment	Social	Governance
Score (1-10)	10	8	8
Weight	25%	50%	25%	ESG score
Weighted score	2.5	4	2	8.5

Scenario 2

Particulars	Environment	Social	Governance
Score (1-10)	7	5	5
Weight	25%	50%	25%	ESG score
Weighted score	1.75	2.5	1.25	5.5

Income-based valuation

In the income-based valuation, for the sake of simplicity, we will make the following assumptions.

• Expected lifespan: 5 years
• Expected EBITDA growth rate: 15%-25%
• No interest payments
• Constant net working capital and depreciation, and amortization
• Discount rate: 12%

Now, we can apply financial modelling to Finnova Venture’s financial performance in the base year, which is as follows.

Period	2024
Earnings before interest, taxes, depreciation, and amortization (EBITDA)	$2,000,000.00
Depreciation and amortization (D&A)	$250,000.00
Earnings before interest and taxes (EBIT)	$1,750,000.00
Tax rate	21%
Tax	$367,500.00
Earnings before interest (EBIT - T)	$1,382,500.00
Depreciation and amortization (D&A)	$250,000.00
Free cash flow (FCF)	$1,632,500.00

Before we go ahead, we must assume the most sensible EBITDA growth rate for each scenario based on the ESG performance. In this example, we shall assume EBITDA growth rates of 22% in scenario 1 and 16% in scenario 2. With this, we can make the following projections.

Projections in Scenario 1

Period	2025	2026	2027	2028	2029
Earnings before interest, taxes, depreciation, and amortization (EBITDA)	$2,440,000	$2,976,800	$3,631,696	$4,430,669	$5,405,416
Depreciation and amortization (D&A)	$250,000	$250,000	$250,000	$250,000	$250,000
Earnings before interest and taxes (EBIT)	$2,190,000	$2,726,800	$3,381,696	$4,180,669	$5,155,416
Tax rate	$0	$0	$0	$0	$0
Tax	$459,900	$572,628	$710,156	$877,941	$1,082,637
Earnings before interest (EBIT - T)	$1,730,100	$2,154,172	$2,671,540	$3,302,729	$4,072,779
Depreciation and amortization (D&A)	$250,000	$250,000	$250,000	$250,000	$250,000
Free cash flows (FCF)	$1,980,100	$2,404,172	$2,921,540	$3,552,729	$4,322,779
Discounted cash flows	$1,767,946	$1,916,591	$2,079,494	$2,257,823	$2,452,861

In this scenario, the company’s valuation would be $10,474,716, i.e., the total discounted cash flows.

Projections in Scenario 2

Period	2025	2026	2027	2028	2029
Earnings before interest, taxes, depreciation, and amortization (EBITDA)	$2,320,000	$2,691,200	$3,121,792	$3,621,279	$4,200,683
Depreciation and amortization (D&A)	$250,000	$250,000	$250,000	$250,000	$250,000
Earnings before interest and taxes (EBIT)	$2,070,000	$2,441,200	$2,871,792	$3,371,279	$3,950,683
Tax rate	$0	$0	$0	$0	$0
Tax	$434,700	$512,652	$603,076	$707,969	$829,643
Earnings before interest (EBIT - T)	$1,635,300	$1,928,548	$2,268,716	$2,663,310	$3,121,040
Depreciation and amortization (D&A)	$250,000	$250,000	$250,000	$250,000	$250,000
Free cash flows (FCF)	$1,885,300	$2,178,548	$2,518,716	$2,913,310	$3,371,040
Discounted cash flows	$1,683,304	$1,736,725	$1,792,772	$1,851,461	$1,912,819

Here, the company valuation falls by 14.3% to $8,977,081.

Market-based valuation

The recently published valuations, SG (Social and Governance) scores, and revenues for Finnova Ventures’ closest peers are as follows.

Startup Name	SG scores	Revenue	Valuation
GreenLedger Capital	9	$3,800,000	$14,500,000
Mint Equity	7.5	$2,400,000	$9,800,000
ClarityVest Finance	8.2	$3,000,000	$13,100,000
Everwise Holdings	6.8	$1,900,000	$7,200,000
TerraTrust Advisory	8.9	$3,600,000	$14,800,000
Beacon Finance	5.5	$2,000,000	$6,300,000
HorizonStack Wealth	7	$2,700,000	$10,200,000
Solvance Capital	6.2	$1,500,000	$6,800,000
EthicaFund Partners	9.2	$4,100,000	$15,000,000
BlueOak Financial	7.8	$2,900,000	$11,600,000

Note: SG scores are calculated by placing equal weight on Social Scores and Governance Scores in this example.

Now, we will calculate the SG-adjusted market valuation multiple using the following formula.

SG-adjusted market valuation multiple = Total valuation of all companies/Total revenue of all companies÷Average SG score
=$109,300,000$27,900,0007.61
=3.917562724÷7.61
≅0.51

Now, let us apply this valuation multiple to both scenarios.

Particulars	Scenario 1	Scenario 2
ESG score (A)	8	5
Revenue (B)	$2,000,000	$2,000,000
Valuation (C = A × B × ESG-adjusted valuation multiple)	$8,160,000	$5,100,000

Thus, we see that a drop of $3.06 million or 37.50% occurs due to poor SG performance when the market-based valuation method is used.

Eqvista – Valuations you can bank on!

Improving your ESG score requires a long-term commitment to fair practices and diligent monitoring. But these efforts can pay back handsomely by making your company more desirable to work for, invest in, and to do business with. For instance, high ESG performance can be a plus when you wish to partner with European companies. As per the Corporate Sustainability Due Diligence Directive (CSDDD), they are required to prevent adverse human rights and environmental impacts in their own operations and across their value chains.

However, if your interpretation of ESG measurement methods differs from that of the relevant agencies, your efforts to improve ESG performance would be misdirected.

This is an area where Eqvista can be of assistance. We can help you interpret ESG measurement methods and thereby enhance your valuation. Contact us to know more!