This paper has examined the effect of ESG scores regarding companies’ enterprise values through the lens of well-established valuation models and empirically external factors in the Nordic countries. We have delved into the topic by looking at 241 publicly traded companies in the Nordics and looked at the connections be-tween excess returns and ESG score performance. Furthermore, we have examined how the ESG scores and attributes of a company affect their valuation and what implications do the scores show regarding the cost of capital. As the cost of equity and debt plays an important role in forming the weighted average cost of capital, that is used to discount future free cash flows in major valuation methods such as discounted cash flow model.
As through the increased importance of ESG factors, we see this as an important factor to look at in the field of M&A as it is a field that could be greatly affected by a new factor in the valuation models very quintessen-tial for the field.
The fundamental basis of our dataset was created through extracting data of publicly traded companies in Den-mark, Finland, Norway and Sweden between 2011 and 2019. After filtering all the companies with, both ESG data and monthly returns, we set out to test our hypothesis of ESG affecting stock returns and thus cost of eq-uity. Values were extracted through Standard & Poor’s Capital IQ while the benchmark index for the Nordic portfolio was Euro STOXX 600, representing small-, mid-and large-capitalization companies across Europe.
Thus, we believe that the index provides the best comparison for the researched effect and data across the Nor-dic countries. Furthermore, we have incorporated ESG scores as a risk measure into our multi-factor model as an additional regressor as well as factor-based on Winner Minus Losers to bridge connections to previous pa-pers regarding our research.
By looking at the analysis and the results of our study, we can see that by looking at the relative performance of ESG score that in our sample predicting winners of tomorrow yields significant results on the Nordic port-folio level. However, when we delve deeper into the different country components of the portport-folio, we come across insignificant values from our regressions, leaving us without a strong indication of the violation of the market efficiency hypothesis. However, as well as other studies covered in this thesis, our study has contrib-uted to the earlier studies with inconsistent results regarding ESG as a risk factor. This was done by adding the
ESG scores in the asset-pricing model described above. Furthermore, the higher Sharpe ratios for ESG formed portfolios yield better investment performance and thus outperform our selected European index between the years 2011-2019. However, our dataset is heavily influenced by the substantial increase in companies that fall into our portfolio, and the increase is most noticeable between the years 2016 and 2017.
Furthermore, on the Nordic portfolio level, we achieve statistical significance from our regressions and thus get a satisfying result supporting our hypotheses since we see a negative relationship between ESG and excess returns. This provides us with implications and interrelations to the valuation of a company’s enterprise value and the impact it has on it. The authors can with these results show that ESG can be incorporated in the calcu-lations for the beta value in a multi-factor model, and by these values see the effect on the total return of eq-uity. Through this, it implies that a higher ESG score leads to a reduction of a company’s cost of equity, which further reduces the weighted average cost of capital by everything else being equal, and then increase the en-terprise value in terms of the discounted cash flow valuation theory.
As we have demonstrated in our thesis that no model or research comes without its pitfalls, and despite the in-teresting results and partial implications to our hypotheses, we see some areas that suffer from minor short-comings. As mentioned earlier, we lack data points to gain significance on the country-level analysis; thus, our regressions show inconsistent and insignificant results. Furthermore, our dataset is biased towards large-capi-talization companies as there is not as much sufficient data on small and middle capilarge-capi-talization companies. The analysis on a country-specific level is heavily influenced by the lack of companies making the total sample for each country just exceed the sample level of 30 companies.
However, the lack of data for each country creates smaller portfolios for each country, making it difficult to make any statistical conclusion on a country level. To make this research more specific, it needs more data re-garding companies in the Nordic countries, as this would for further studies help to evaluate and examine ESG scores and financial theories. The authors cannot find enough evidence or statistically significance to conclude any of the results but can only support the progress of ESG ratings towards more companies and especially the small capitalization companies as it would benefit the research and discussion within this area.
To support the findings regarding the ESG scores effect on the return of equity, a similar regression was made on the total enterprise value. The results supported the main analysis but did also support the other few empiri-cal studies touching this research area. This analysis was made along with other financial values such as the cost margin and return on invested capital, where the results also supported the governance theories such as creating shared value and how it benefits in the long run for the company.
All in all, these results do highlight the importance of having a higher ESG score in the world of merger and acquisition. The results will give an indication of how it is possible for advisers to do the due diligence in a different way and to do better screenings for their clients when looking for acquirers or targets. From the com-pany perspective, it supports the empirical studies and theories about having a sustainable strategy aligned with the company’s future plans, as it can be beneficial for target companies to make them more attractive and create more value for the sellers for the time they decide to sell. For acquirers, it has a different view, as it may increase the value of the target company. However, the gain more on the return on invested capital, making the target company more attractive in the long run compared to a company with a less sustainable company strat-egy and implications, everything else being equal.
As this topic combination of ESG and M&A have not been through much research, then there is still plenty of undiscovered areas. As mentioned, the authors view on ESG and M&A could be divided into two main areas like the financial and the human/organizational area, making it interesting for those subjects that yet needs to be researched and discussed. Taking into consideration that the M&A world is a highly attractive area for re-searches then it is recommended to further study ESG and its relationship with M&As, as the authors strongly believe that it will only be more relevant in time and data will only get quantitative and qualitative improved.