Investment managers consistently look to identify factors that will drive future corporate financial performance in order to generate future returns. However data that hasn’t historically been considered in “traditional” financial analysis, such as information contained in corporate sustainability and Corporate Social Responsibility (CSR) reports, is often overlooked.

This oversight is worth noting, as these reports can contain rich information about operations and plans for the future that investment managers are unlikely to find elsewhere. In these reports, corporate executives typically describe operational objectives related to environmental, social and governance (ESG) issues, such as reductions in carbon emissions, improvements in workplace health and safety, and extension of community engagement, the corporation’s approach to achieving objectives in these areas and its progress to date.

Information in sustainability or CSR reports can prove helpful indicators of management quality. Standard financial measures typically look backward and report on current success. Objectives and approaches in Sustainability and CSR reports, on the other hand, look forward and reveal prospects for future success. In many cases, ESG performance can directly impact a corporation’s ability to expand to new markets, attract knowledgeable and skilled workers, and access key resources— important factors in considering a corporation’s prospects for future financial performance.

Integrating ESG factors into the decision-making process

Like traditional factors that impact corporate value, some ESG factors are quantitative in nature, while others are qualitative. Investment managers are already equipped with the skills to evaluate the impact of qualitative factors on corporate value— they often consider brand value, reputation, innovation, intellectual capital, and regulatory risk across a variety of sectors. One way that investment managers can begin the process of ESG integration is by assessing and comparing the information in corporations’ sustainability or CSR reports and determining how that information best fits into their particular decision-making process.

One specific method of integrating ESG factors into the decision-making process is using them to enhance valuation models. The Discounted Cash Flow (DCF) model is an ideal instrument because its cause-and-effect-driven structure is designed to build on both quantitative and qualitative assumptions. Using information from sustainability and CSR reports, which often deals with long-term issues and objectives, could help investment managers lengthen the explicit forecast period and, potentially, the accuracy of the model.

Some approaches to enhancing DCF models with information from sustainability or CSR reports are listed below:

• Examine corporate ESG innovation and intellectual capital in order to make assumptions about revenue growth.
  
  
• Compare competing corporations’ approaches to improving ESG performance in order to estimate competitive advantage and adjust revenue growth.
  
  
• Assess operational goals related to ESG performance in order to forecast operating costs.
  
  
• Evaluate exposure to carbon legislation or increasing commodity prices in order to adjust operating costs.
  
  
• Inspect the corporation’s progress towards stated ESG goals and corporate executives’ ability to reformulate unsuccessful strategy, in order to determine corporate management quality.
  
  
• Adjust beta values based on forward-looking assumptions about corporate management quality.

Using a DCF model to capture assumptions about ESG factors is just one of many approaches to integration. Throughout the field, approaches to integration vary across investment managers and specific strategies.

Gaining an informational advantage

Corporate sustainability and CSR reports can provide valuable forward-looking information about corporate operations, innovation, intellectual capital and management quality. This information can better equip investment managers to make better assumptions about competitive positioning and future financial performance. Because most investment managers do not attempt to consistently incorporate ESG factors into valuation, those managers that regularly consider these factors and their impact on value may be able to better identify attractive stocks before the broader market does. Only about 15 of the 1,518 strategies that Mercer has rated have been assigned the highest ESG ratings of ESG1 or ESG2, and, according to the 2008 PRI Report on Progress, only 39% of investment managers that are signatories to the Principles for Responsible Investment have incorporated ESG issues into their decision-making process for developed market equities.

The process of integrating ESG factors into DCF models, as one example of ESG integration, shows how forward-looking ESG information can strengthen a manager’s perception of both risk and opportunities. As global demographics and government regulation change, consumer preferences shift and resource availability changes, investment managers capable of looking forward with an eye on ESG may be better positioned to find the companies with robust competitive advantages.