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H O W D O N O R D I C C O M P A N I E S ' E S G A T T R I B U T E S I M P A C T T H E I R

V A L U A T I O N M O D E L S U S E D I N M & A ?





This thesis contributes to the valuation of companies examining the effect of Environmental, Social and Gov- ernance, the ESG factors in major valuation models as an additional layer treating it as a risk component. Ad- ditionally, it looks at the empirical work done to support or disrupt our hypothesis regarding the research.

We look at the best percentile stocks that perform high regards to their ESG scores and compare them to the lowest percentile. We look for links in ESG performance and excess returns as well as factor risk into well- established valuation models to look for any implications the scores have on firms’ enterprise value.

Bridging into our econometric approach, comparing high ESG performing companies with low performing ones, the thesis takes use of the capital asset pricing model and Fama & French multi-factor model integrating ESG as a risk in the model. Additionally, we look at the effects on valuations through discounted cashflow model based on the findings of the two earlier introduced models. This thesis’ main focus lies in observing the aforementioned aspect on the Nordic level but does delve into the country level as well, covering Denmark, Finland, Sweden and Norway in order to pinpoint differences and supporting findings. Furthermore, we ana- lyze the interrelation between the return on invested capital, ROIC, and ESG scores as ROIC can be used as a benchmark for the use of capital in an efficient way.

This thesis establishes a connection between winners of tomorrow and the ESG scores on the Nordic level with a significant result from the regressions. Additionally, we find that the companies with higher ESG score have lower cost of equity, affecting their cost of capital and, therefore, the enterprise value of the firm. The thesis also pinpoints a positive relationship between ROIC and ESG scores as when the scores increase by one, the average ROIC in the Nordics increases by 0,1 percentage point. The analysis also found out the relation- ship between total enterprise value and ESG scores to have a highly positive relationship and to be statistically significant on a one percent level. Overall, our regressions and statistics imply a potential benefit of investing in a company within the top percentile regarding its ESG score.

Nevertheless, findings based on earlier studies and the research of thesis reveal a positive relationship between excess returns and ESG scores as well as an effect on a lower cost of capital leading to a higher enterprise value of a company. For the Nordic markets, ESG can be seen as a risk factor and thus is important to be taken into investment decisions. Lastly, this thesis concludes by discussing the importance of corporate governance in the world of mergers and acquisitions in regard to ESG.


Table of Contents

Abstract ... 1

Table of Contents ... 2

Introduction ... 4

Research Questions ... 5

Visual presentation ... 6

Literature Review ... 7

Merger and Acquisition ... 7

ESG ... 14

Theory ... 17

Portfolio Theory ... 17

Discounted Cash Flows ... 19

Capital Asset Pricing Model ... 23

Fama French Multi Factor model ... 27

Carhart Four Factor Model ... 28

Econometrics ... 29

Data ... 34

ESG Score ... 35

Benchmark ... 36

Methodology ... 39

The research philosophy ... 40

Techniques and procedures ... 43

Data preparation ... 43

ESG Score ... 43

Model factors ... 45

Portfolio ... 47

ESG Factor ... 47

Portfolio Evaluation ... 48


Econometric considerations ... 51

Selection bias ... 53

Analysis ... 53

Nordics ... 53

Denmark ... 59

Finland ... 64

Norway ... 68

Sweden ... 73

Financial values... 78

Cost Margins ... 78

Return on invested capital ... 80

Total Enterprise Value ... 82

Discussion ... 83

Data and Methodology ... 83

Market efficiency ... 84

ESG & Mergers and Acquisitions ... 85

Corporate Governance ... 87

Conclusion ... 88

Bibliography ... 91



The shift to the age of Anthropocene has given the world demand for recalibration and adjustment. This, of course, affects all of the industries and everyone on our beloved planet. Since we are business students and we are passionate about the world of M&A and the evolving world of environmental, social and governance, ESG, we set ourselves to delve into these two topics in a combined manner. When we talk about ESG, we re- fer to ‘three central factors in measuring the sustainability of an investment.’ ESG can be used as a synonym for sustainability, investing and looking at businesses’ operations, and contributing to sustainable develop- ment. However, Environmental criteria examine how a business contributes to and performs on environmental challenges. Social criteria look at how the company treats people, while Governance criteria examine how a company is governed (Henderson, 2019).

As times change, there is a change that needs to occur in our business practices to adopt new ways of doing business. As the topic is relatively new to the world of finance, it comes as no surprise that ESG and its effect on the financial world are almost universally top of mind of executives at BlackRock and Vanguard. Also, ESG has become very important, especially in the Nordics as ‘97% of Nordic investors viewed it as ‘very im- portant’, while climate action, affordable and clean energy, as well as clean water and sanitation, were cited as the most important components of the Sustainable Development Goals.’. Furthermore, this shift in motive and stance towards ESG factors has made companies and investors and the financiers, employees, and other stake- holders and are heavily influencing M&A transactions. Thus ‘s environmental, social and governance (ESG) factors have become a growing focus for companies and their shareholders, financiers, employees and other stakeholders, they have also become increasingly crucial to the success of M&A transactions.’ (Terry et al., 2021; Eccles & Klimenko, 2019; Sloley, 2020).

As we can see that there has been increased investor interest towards ESG and its affiliations to the stock mar- ket and company valuations. However, the building blocks of such information begins with the data. As com- panies have not had any pressure to release information about their ESG performance, there has not been much data to look at. However, during the past years, ESG rating agencies have emerged and now provide ESG scores that mirror the sustainable performance of the companies. This, of course, has added another layer in making investment decisions for individuals and institutions interested in building portfolios and companies that look for inorganic growth strategies. Thus, some companies might start looking into ‘ESG diligence’, fo- cusing on ‘sustainability and ESG issues relating to the target company’. However, much like credit ratings, ESG scores act as information that affects the cost of equity and debt and follows the share price and


company’s enterprise value. This information impacts the share prices and the overall valuations, thus provid- ing opportunities for profit and loss (Terry et al., 2021).

This thesis aims to examine 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. Furthermore, we will look at how the ESG scores and attributes of a company affect their valuation and what implications do the scores show regarding the cost of capital. Additionally, we will define if companies with high ESG scores outperform stocks with lower scores and relation to excess returns. This will give us insight into the size of the potential impact that ESG can have in Mergers and Acquisitions.

Research Questions

Throughout the paper, the authors try to research and examine the following research questions.

How does the ESG score affect a company's enterprise value through well-established valuation models and empirically external factors in the Nordic countries?

1. How can a risk ESG score be incorporated within Merger and Acquisitions?

2. Does a higher ESG score lead to a higher enterprise value of the company?

3. Does the effect of a higher ESG score tend to be stronger in one country than the others in the Nor- dics?

4. Does the ESG Score have a positive relationship with companies’ financial values?

Bibliometrics, informetrics and scientometrics are all techniques within information science. The approach is different in each term but combined in different stages of the information search, and it can derive the neces- sary information, where these can be analyzed into a better understanding of the research questions (Diodato, 1994).

Using bibliometrics, like Scopus, shows patterns or trends in the published research to create some sort of overview of the qualitative data, especially with the number of publications about M&As. Diodato (1994) ar- gues that bibliometrics is the same as informetrics. However, it also examines the patterns that show up in life, which in terms of this paper would be trends or tendencies in human behaviour. This later will be used in sci- entometrics to see the effect and importance of ESG in M&A (Diodato, 1994).


It may be argued that this paper contributes to the Barnaby Rich effect, which is a hypocritical attitude toward over publication. By looking at the total amount of published papers regarding M&As, it is impossible to dis- tinguish the overall conclusion in various subtopics. However, the importance of trends in M&As is argued to have shown importance. Therefore, looking at the number of published papers regarding including ESG, sus- tainability, governance, etc., when companies are doing M&As are limited, and therefore, can the Barnaby rich effect be rejected regarding this paper (Diodato, 1994).

Visual presentation

Figure 1: Visual presentation of the two created analysis made in this paper

(Authors’ own creation, 2021).


Literature Review

Merger and Acquisition

Merger and Acquisitions, M&As, are the context of when a company acquires or merges with another com- pany due to strategies to grow or expand within new or unknown markets. These mergers or acquisitions tend to happen due to competitors buying to gain more market share, strengthen their product portfolio or penetrate the business into a new market. In takeovers or buyouts, it is more a generic change of ownership of the com- pany. The management usually uses M&As to improve performance and capture synergies. However, different barriers such as cultural differences, miscalculated synergies, excessive debt can negatively impact the compa- ny's post-acquisition performance. Multiple studies show that M&As have a positive impact post-acquisition, whereas others exhibit a negative impact, meaning that M&As impact is not conclusive (Depamphilis, 2019;

Ferreira et al., 2014).

M&As performance has been studied for decades, and the various conclusions can support the statement above. Studies in 1988 and 2000 showed that there was no evidence of abnormal returns for acquiring share- holders, which were measured on the US, UK, and Canadian markets. However, Bradley et al.'s (1988) studies showed positive effects, primarily through synergies in the US market. Goergen and Renneboog (2004) found evidence of positive abnormal returns in mergers and friendly acquisitions in European M&As. Thus, domes- tic M&As triggered a higher effect than cross-border (Franks et al., 1998; Eckbo & Thorburn, 2000; Bradley et al., 1988; Goergen & Renneboog, 2004).

As M&As can be made within different methods and payments, then Rose et al. (2017) found a positive corre- lation between cash flow and cumulative abnormal returns in M&As payments in cross-border transactions in the Nordics, saying that this might be an attractive attribute. Their analysis also showed that the average an- nouncements returns were lower when it was cross-border transactions. However, their research also showed that the Nordic stock markets behaved differently compared to the US or UK markets (Rose et al., 2017)

The amount of published literature about M&As is overwhelming. From 2000 to 2020, there have been 11.848 articles published regarding M&As, amounting to almost a thousand articles each year. We took the approach to further narrow down the article to 2.222, where the research area lies within economics, econometrics, and finance, where 961 of these are specifically about M&As. To get an overview of the most relevant articles


published regarding our field, we chose to focus on those articles that further researched synergies, govern- ance, and risk (Scopus, 2021).

According to Bowen (2016), there are two ways of generating value in an M&A deal; the first one stems from the company being undervalued and the other from revenue and cost synergies. In addition to this, it is intri- guing to look at whether SRI can impact these synergies. Aktas et al. (2011) found statistically significant at the 1% level that an acquirer with a high level of SRI was receiving a higher cumulative abnormal return for shareholders in announcements than a low-level SRI acquirer. They suggest that expected synergies are more critical when the target is a high-level SRI company (Bowen, 2016; Aktas et al., 2011).

When looking at the previous empirical studies, Zola and Meier (2008) showed that in the years between 1970 and 2006, there were 12 different approaches to measure M&A performance. They looked at 88 empirical studies, whereas 12 studies used synergy realization or realization of strategic objectives. These studies showed in event studies of premerger event returns and postmerger accounting returns to check whether there are atypical stock returns. The studies assume that investors can define if the M&As can realize the expected synergies successfully or not when the deal is announced (Dempamphilis, 2019; Zola & Meier, 2008;

Bargeron et al., 2014).


Synergy is the value a company calculates from the incremental cash flows when combining two companies.

This effect is best explained as two plus two is equals five, as combining resources, management, or

knowledge can lead to a more beneficial situation collectively. Synergies can be found in terms of operating- and financial synergies where operating synergies are achieved through economies of scale, economies of scope, or technically complementary assets. Financial synergies can be achieved in several ways, where in some cases, the outcome might amount to lower cost of capital, push the company to a higher growth market threshold, or strategic realignments (Depamphilis, 2019; Bradley et al., 1988).

Bradley et al. (1988) analyzed 721 target firms in the years between 1963 and 1984 trading on the US stock exchange. By looking at the combined wealth of target and acquirer shareholders, they analyzed the tender of- fers within similar target and acquisition firms in the market. The tender offer is often known as a hostile take- over, as it doesn't need acceptance from the target firms' shareholders to get proceeded. A tender offer is when an acquirer offers a price of the target firm shares, which is the market price, including a premium. They here- after assume that the obtained possible synergies lie within the acquirer exploiting a profit created by a change in economic conditions such as operating- and financial synergies (Bradley et al., 1988).


As Bradley et al. (1988) argued for the importance of identifying operating- and financial synergies, Fich and Nquyen (2020) argued that M&As are filled with asymmetric information among the bidders and target com- panies. Their findings showed that M&As cases where the bidder had some of the same knowledge on the market where the target company was operating also created a more profitable acquisition. Further research showed when the bidder had experience or expertise in the same supply chain as the target firm, which ena- bled an increase in the expected operating synergies (Bradley et al., 1988; Fich & Nquyen, 2020).

The later study of Goergen and Renneboog (2004) also analyzed the wealth effect and the increased amount of M&As in Europe in the 1990s. Their method is also based on the historical stock market data, calculating the abnormal returns for the company as the difference between the actual daily returns and the expected return.

Furthermore, they retrieved the results from a multi-factor capital asset pricing model (CAPM) formula. When the abnormal returns were calculated, they could use it to test the cumulative average abnormal return over the event stage for target and acquirer combined (Goergen & Renneboog, 2004).

Their results showed that bidding firms in Europe made statements about the potential synergies, but these were rarely achieved, indicating that bidding firms made an over-optimistic forecast or that the intention of the takeover was due to managerial hubris or other agency problems. However, to test whether synergies were the main motives of takeovers, they assumed that managers from the target and acquire firms intend to maximize the value to shareholders. This created a hypothesis that the wealth gains for target shareholders should be pos- itively correlated with the bidder shareholders and the total wealth effect. Goergen and Renneboog (2004) cre- ated another hypothesis to look at potential hubris as the motivation for the takeover. To test this hypothesis, they expected the total gain to be zero and a wealth transfer from bidder to target with a negative correlation (Goergen & Renneboog, 2004).

Their results showed that there was a positive correlation on the event day that in their total sample, there was a significant level, and even over their long-time window continued to show a significant positive correlation.

These results suggested that large M&A bids in Europe were motivated by synergies. In addition to the for- mer, it was shown that M&As had no correlation between target's gains and total gains, and in only M&As where the total gain was negative, they found a negative correlation between target's gains and bidder's gains.

This, suggesting managerial hubris was responsible for a third of the M&As in the sample. This result may also raise questions about the governance in European companies when deciding to make an M&A or not (Goergen & Renneboog, 2004).

It is argued that it is necessary to identify the operational- and financial synergies for international companies when doing M&As, as operational synergies have a significant effect on the capital value and financial


synergies create an appreciation of the new company stock. Meanwhile, it is shown that companies spend more time realizing the expected synergies, making it more difficult for the acquirer to meet the expected fi- nancial returns expected from the shareholders. This is also supported by Goergen and Renneboog (2004), as they found a positive correlation between target gains with bidder gains and total gains, suggesting that syner- gies are the prime motivation for M&As in Europe (Kwilinski et al., 2020; Dempamphilis, 2019; Goergen &

Renneboog, 2004).

Corporate Governance

In 2013 The Economists created a report about governance in the Nordics and called it 'The next supermodel.' (The economist, 2013). The Nordic countries are similar, and with the recent achievements of economic suc- cess, happiness, and social health, they caught the attention of other countries worldwide due to the similarities in the public sectors and maximize transparency (The Economist, 2013).

When looking at the corporate governance of the Nordics, there are many similarities to be found. One of the similarities can see in the minority shareholder rights across the countries. Minority shareholders can require an extraordinary general meeting when the shareholder minority is a minimum of 5% in Denmark and Norway and 10% in Sweden and Finland. Even if the shareholder minority is 10% in all countries, 2,5% in Denmark believe that something within the company needs an in-depth investigation. In this case, minority shareholders can demand the court to appoint a special investigator on the company's expenses (Lekvall, 2014).

The Nordic governance structure differs from the one- and two-tier model, in which the general meeting has the ownership level, the board has the oversight and control level, and the executive management has the exec- utive level. Norway has a corporate assembly where companies with over 200 employees are required to have this division. Its primary purpose is to give the employees a saying regarding decisions to the company's work- force. Employees make one-third of the total members of the division (Lekvall, 2014).

Corporate governance has been described as the way suppliers of finance to the firm assure a return on their investments. However, Tirole (2005) argues that corporate governance is not entirely focused on investment returns, but other stakeholders like employees, communities, suppliers, or customers have an interest in where the firm is heading and how it is controlled (Tirole, 2005).

When the board of directors gets analyzed in studies, they usually categorize them as inside and outside direc- tors. Inside directors are categorized as those who are full-time employees at the firm, and the outside directors are those whose primary employment is not within the firm. Outside directors can be in the form of a stake- holder representative and usually working for the labor environment. It is argued that even though this


representative can affect the firm policies at the expense of the shareholders, then the benefits created to asso- ciate with better performance and, therefore, in the end, benefits the shareholders (Adams et al., 2010).

It is hard to determine how the board of directors affects a firm's performance by looking at econometrics. In this area, studies investigate differences across the boards and the board structures. Adams et al. (2010) ana- lyzed the different roles of the board in corporate governance and tried to define what is ‘poor governance’

and why companies choose the specific to be labelled as ‘poor governance.' Doing their research, they discuss the different modelling approaches based on the idea of information transformation between the CEO and the board of directors. In addition to this, the authors argue that the information transformation between the two is an important variable to create ‘good governance’. This becomes relevant, especially the situations where the CEO and the board of directors have different choices of strategy (Adams et al., 2010).

By combining different literature about the relevance of information transformation between the CEO and the board of directors, Adams et al. (2010) could derive variables and how these affected each other. It showed that the firm value increases when the quality of the board increases, when all else is held equal, and given the board turns down all projects with a negative net present value. However, it is also highlighted that CEOs will require a higher compensation from the board when dealing with projects with a higher risk. The firm gener- ates a lower optimal quality of the board when the economic conditions are good and vice versa. Therefore, leading to a board that is more willing to let CEO go ahead with projects when the economic conditions are good (Adams et al., 2010).

The information transformation and the advice given across inside and outside directors of the board is viewed as valuable when the company is during an M&A. It is argued that the social ties between the CEO and target directors are negative when the directors need to discipline the manager but are increasing the abnormal return on the announcement for the acquirer when the target directors are more ‘friendly’ and more willing to share valuable information (Adams et al., 2010).

As the director's duty is to protect shareholders' interests, then it could be the case that the interests are not per- fectly correlated. To increase a director's motivation lies the total compensation in terms of annual compensa- tion and various incentives, including attending meetings, stocks, options, and bonuses connected to the com- pany's performance. A study on the fortune 500 companies in 2004 found evidence that the average outside director gained 11 cents for each 1.000 USD increase in the firm value, accounting for the total compensation received and keeping board structure (Adams et al., 2010).


Besides the compensation, there is also the directors' concern about their reputation that can affect their behav- ior. These reputational concerns might be the source of new agency problems. This meaning that directors tend to shy away from risky projects. Since they prefer less noise regarding their decisions to maintain their reputa- tion, so that they can either get reelected to the board or increase their chances of getting a seat in another board (Adams et al., 2010).

Tirole (2005) argues that when the management is not acting in the best interest, the moral hazards can be di- vided into four segments. The first is insufficient effort, where managers cut costs to cheaper options or focus more on competitive activities, such as boards of directors, political involvement, investments in other ven- tures, etc. The second is extravagant investments, where managers are more eager to engage in side-projects that are not benefiting the shareholders. The third segment is entrenchment strategies, which look at managers who are willing to take actions that hurt shareholders but are helping to secure their management positions.

The final and fourth segment is self-dealing, where managers might take actions that bring in private benefits (Tirole, 2005).

To meet these types of dysfunctional corporate governance, Tirole (2005) states that more transparency and a clear link between the firm's performance and managers compensations. Compared to the Nordic governance model, these criteria are being met by the Nordic countries since they try to maximize the performance trans- parency to the public and the stakeholders. However, it lacks a clear link between the firm's performance and compensations (Tirole, 2005; Lekvall, 2014).

The role of the board of directors could be described as monitoring the management for the shareholders. One of their responsibilities includes approval of major decisions, such as M&As, and offer advice or a connection to the firm's management. The important question arises when asked if the decisions made are always in the best interest of all the shareholders of the company. Tirole (2005) mentions a few reasons why directors would have indolent behavior instead of causing trouble in the board. He mentions reasons like lack of independence, insufficient attention, insufficient incentives, and avoidance of conflict. Avoidance of conflict describes the relationship between the board of directors and management, as Tirole (2005) found evidence regarding the directors' dislike of confronting managers, as they have incentives to be reelected to the board. Nevertheless, when speaking of takeovers, the board may refuse to settle with management decisions if management is cur- rently underperforming (Tirole, 2005).

As mentioned, Tirole (2005) discusses the relevance of viewing corporate governance as a mechanism to max- imize shareholder wealth and have the stakeholder's interest in mind and be responsible for social purposes.

The Corporate Social Responsibility (CSR) view shows the company's duties towards different stakeholders


and how the firm can benefit society. To do so, Tirole (2005) set up the ideas for a stakeholder society govern- ance structure and with arguments for and against implementing this structure in the firm (Tirole, 2005).

First, it discusses the need for laws, where European countries traditionally have more regulatory sympathy towards stakeholders than the United States of America. The need for laws and regulations is discussed to bal- ance the bargaining power towards stakeholders, but this raises the concern of whether it is serving its goal in the long run, as it may discourage investments and job creation. However, there is also a viewed objection to the stakeholder society government structure, where arguments for giving non-investors control can discour- age financing. Concerns about shared control lead to conflicts in decision-making, managerial accountability that may be unmeasurable, or that successful CSR initiatives impose more tax on the business (Tirole, 2005).

To get a deeper insight into how corporate governance can affect M&As, we can draw similarities from Ad- ams et al.'s (2010) and Tirole's (2005) studies with the study from Hayward and Hambrick (1997) as they ex- amine the role of CEO hubris in large acquisitions. Furthermore, they explore the relationship between CEO hubris and premiums and their connection to the board of directors (Hayward & Hambrick, 1997).

Hayward and Hambrick's (1997) results showed that CEO hubris created by pride, self-confidence, and recent company performance attributed to increasing the premium that acquirer was willing to pay as the greater the confidence is in their abilities, the greater the possible benefits that the CEO believed was attainable. The au- thors further investigated these higher premiums and higher achievable goals in terms of synergies created by hubris through the role of the board of directors. Their results showed that the more significant fraction of in- side directors in the board created a higher effect of hubris on acquisitions and that outside directors could have a more conservative approach to protect shareholders' interest which would moderate the acquisition bids (Hayward & Hambrick, 1997).

Whether there is a barrier from the board of directors or their behavior in the decision-making of more sustain- able takeovers, the arguments above are supported by various studies. Thus supporting the growing interest in research within the board of directors' role and their effect on external factors. However, there are studies since 1988 that show that the outside directors tend to be more shareholder-friendly and might impact the decision making of more sustainable or more risky investment (Adams et al., 2010; Shivdasani, 1993; Weisbach, 1988).

Bringing the general view of characteristics of the board of directors in the Nordic countries is research itself but has been done recently by Hundal and Eskola (2020). Overall, their findings showed a strong impact of the board of directors' characteristics on the company's capital structure and a weaker effect on the investments and financial performance. It showed that a relationship within intangible and financial investments


(ASSETS?) required high education and experience within top leadership. In addition to this, it also showed that the size of the board and the age of the board affected the systematic risk negatively and that education, gender, and business affected the systematic risk positively (Hundal & Eskola, 2020).


In recent years Environmental, social, and Governance, ESG, has increased its importance across different sec- tors and is on the course to increase even more. However, it plays as Kell (2018) pinpoints a crucial part in the financial industry, the industry where the majority of matters are approached through the lens of numbers, as in 2004, the term 'ESG' in a landmark study of 'Who cares wins' that made some space for discussion about integration of ESG into the financial world. Thus, we have begun to understand the importance of non-finan- cial aspects in value creation as 'ESG factors cover a wide spectrum of issues that traditionally are not part of financial analysis, yet may have financial relevance.' (Kell, 2018;Janus Henderson Investors, 2019).

In the past years,, the concept of environmental, social, and governance, ESG, has seen growth in applications to different industries and companies' future strategies across different sectors. Thus, 'in the past 25 years, the world has seen exponential growth in the number of companies that measure and report environmental data (e.g., carbon emissions, water consumption, waste generation). Furthermore, they report social data (e.g., em- ployee makeup, product information, customer-related information), and governance data (e.g., political lob- bying, anti-corruption programs, board diversity)—that is, ESG data.' (Amel-Zadeh & Serafeim, 2018).

However, Amel-Zadeh and Serafeim (2018) highlight in their research that 82% of respondents use ESG data due to its correlation with investment performance. Others believe that 'engagement with companies can bring change in the corporate sector to address ESG issues. Hence, when we speak of ESG and the implementation of ESG into corporate and board strategy, we refer to the aforementioned definition. This is not only relevant for pushing the world from the age of Anthropocene, but it is also a critical factor in M&A transactions and overall activity. Furthermore, 'M&A deals are leading to heightened environmental standards for companies across the board as well as ESG is taking a more and more important role in due diligence (Franklin, 2019;

Amel-Zadeh & Serafeim, 2018).

ESG effect on company value

Although research has established positive relations between ESG and share price performance, the effect var- ies depending on the industry's sensitivity. In the more sensitive industries, the value-creating effect is lesser than in the firms that do not belong to sensitive industries. Furthermore, the corporate governance practices of


a firm play a significant role in the share price performance. However, companies located in countries with a high level of press freedom, more followed by analysts, and generally larger tend to have a greater impact on the market value through corporate social performance and ESG (Yoon, Lee & Byun, 2018).

Thus, Aouadi and Marsad (2016) argue that smaller firms performing at a lower level can be found to be lo- cated in countries with less freedom of press struggle to create a positive link between share price performance and ESG. Risk plays an important role when looking at the effect of value creation and share price perfor- mance as ESG links the movement of correlation through idiosyncratic, systematic, and total risk (Sassen, Hinze & Hardeck, 2016; Aouadi & Marsad, 2016).

Environmental performance tends to decrease the idiosyncratic risk, while systematic risk and total risk are only affected only in environmentally sensitive industries. Thus, having a 'significantly negative effect on all three risk measures' Sassen, Hinze & Hardeck, 2016). As the correlation is negative with the aforementioned risk types, we know that risk correlates with the price of stocks following the efficient market theory. We can, based on the above literature mentioned, conclude that ESG can be said to have a positive effect on share price performance and firm value not only through firm perception of the public but through lower firm risk (Sas- sen, Hinze & Hardeck, 2016).

ESG effect on equity valuation

Looking at a company's ESG characteristics can provide fruitful insight as a financial indicator. Thus, to gain a deep understanding of the effect of ESG on company value, it is essential to look at how companies' attributes regarding ESG transmission into modern financial valuation methods. In other words, we rely on traditional corporate finance in establishing the transmission channel in ESG (Giese et al., 2019).

Gregory, Tharyan, and Whittaker (2014) show that the company's ESG profile on cash flows, cost of capital, and risk can be examined by looking at discounted cash flow, DCF, model framework. Thus, the research pin- points the importance of differentiating between the systematic and idiosyncratic risk of equities. The system- atic risk is something that all companies are exposed to, while the idiosyncratic risk is firm-specific. Further- more, the authors highlight that the firm-specific risk is affected by the ESG attributes, affecting the cost of capital, leading to scenarios where future cash flows are discounted at lower or higher rates depending on the company's stance regarding ESG (Gregory et al., 2014).

As the cost of equity decreases, the firm value increases resulting in a higher valuation of the firm. Not only does the firm value increase due to lower cost of equity but also through 'better long-run growth prospects' (Gregory at al. 2019). Guide et al. (2016) also distinguish the benefit of integrating ESG rating in financial


analysis. In a nutshell, ESG metrics serve an important role when looking at firm value and provide a clear un- derstanding, through traditional financial modeling tools, of how exactly ESG affects firm value (Guide et al., 2016).

On the other hand, there is literature that challenges the observations mentioned above of the positive correla- tion between ESG and Corporate financial performance. Thus, Friede, Busch & Bassen (2015) find that from a dataset with over 2000 observations, 90% show a nonnegative relationship between ESG and CFP. However, this is not to overlook the importance of implementing long-term value-enhancing ESG factors. Furthermore, Groening and Kanuri (2013) find that almost 50% of the time, in the occurrence of positive corporate social events, investors may not reward the firm. At the same time, a negative corporate social event might lead to the company being rewarded by the investors (Friede, Busch & Bassen, 2015; Groening & Kanuri, 2013).

Corporate Social Responsibility

Corporate Social Responsibility (CSR) has gotten multiple definitions in the last couple of years. It is a term widely used by companies and within their departments when speaking of creating a better future for our soci- ety. According to the CSR literature review by Rong-Jia and Xiao-Wen (2015), CSR can be divided into two definitions multi-dimensional definitions and social marketing definition. The first definition covers social re- sponsibilities for corporations, whereas the second is dealing with CSR according to its impact on society (Rong-Jia & Xiao-Wen, 2015).

As there have been publications about CSR since the 1960s, we can see an evolution of CSR throughout the years. Some findings show a connection between the social expectations of corporate behavior and how CSR is viewed. Thus, CSR's future is highly affected by the corporate environment and its contribution to business frameworks and strategies (Agudelo et al., 2019).

Creating Shared Value

Michael E. Porter and Mark R. Kramer (2019) stated the increasing view of businesses and them being the cause of social, environmental, and economic problems worldwide. This happened by their logic that compa- nies are prospering at the expense of the broader community. Companies today possess an old narrowed ap- proach to create value in terms of increasing performance in the short-term, not by looking at the influence they can create and determine their future long-term success. They argue that companies must take the lead in today's world to bring back business and society together and create a more general framework for guiding companies instead of being stuck with the ‘corporate social responsibility’ view (Porter & Kramer, 2019).


Their idea to change this view in companies worldwide is by looking at the principles of shared value, creating economic value, which also leads to a value for society by pointing out the needs and challenges. However, this is already being implemented in major companies like Google, Intel, Johnson & Johnson, etc., which are looking at creating shared value and are taking the first steps towards an intersection between corporate perfor- mance and society. Porter's and Kramer's (2019) idea can be narrowed down to three key approaches: compa- nies can create shared value opportunities by reconceiving products and markets, redefining productivity in the value chain, and enabling local clusters developments. This would help companies to look at their businesses and generate new approaches with more modern and better innovation and growth opportunities resulting in beneficial solutions to the society (Porter & Kramer, 2019).

Creating shared value focuses on the idea that societal needs and economic needs define the markets and rec- ognize the company's internal costs created by wasted energy, wasted raw materials, costly accidents, or other social harms and weaknesses. Addressing these harms and weaknesses is not equal to increasing the firm's costs, since innovative technologies can eliminate these, new operating methods, or a new way of thinking in management approaches and thereby increase their productivity and further expand their markets. However, it might result in some initial investments from the companies. Still, the following return will generate greater economic value and strategic benefits for the companies, shareholders, and stakeholders (Porter & Kramer, 2019).


Portfolio Theory

Harry Markowitz introduced the mean/variance portfolio optimization technique in a Journal of Finance article in 1952. The technique allows the investor to find the portfolio with the highest expected return for any level of volatility or variance. It is a cornerstone theory to other theories like the CAPM and holds high relevance to this date. The main idea of Markowitz's theory was that the investment risk of security could not be deter- mined in isolation as it is the security's covariance with the investor's portfolio that determines its incremental risk (Markowitz, 1952). However, it is essential to remember that Markowitz's theory is 'normative' while, for example, Sharpe's asset pricing theory, CAPM, is a 'positive theory'. This meaning that while the 'one that de- scribes a standard or norm of behavior that investors should pursue in construction of theory' while the latter theory hypothesis how investors behave and not how they should behave. Furthermore, Markowitz included


various assumptions of investors and the market in general, which play an important role in the theory. He built his portfolio selection contribution to modern portfolio theory based on seven key assumptions (Man- gram, 2013; Markowitz 1952):

1. Investors are rational (they seek to maximize returns while minimizing risk)

2. Investors are only willing to accept higher amounts of risk if they are compensated by higher ex- pected returns

3. Investors timely receive all pertinent information related to their investment decision 4. Investors can borrow or lend an unlimited amount of capital at a risk free rate of interest 5. Markets are perfectly efficient

6. Markets do not include transaction costs or taxes

7. It is possible to select securities whose individual performance is independent of other portfolio in- vestments.

James Tobin expanded on Markowitz’s theory by introducing risk-free investments to the portfolio. He al- lowed investors to ‘combine risky securities with a risk-free investment. Thus, this led to a unique optimal portfolio of risky securities which did not depend on investors’ tolerance of risk. Furthermore, Sharpe (1964) delved further and further advanced the efficient frontier and capital market line concepts in his creation phase of CAPM. A year later, from Sharpe’s establishment Lintner (1965) used the corporate stock issuance ap- proach in deriving the CAPM. Thus, all of the above, showcasing the deeply rooted joints of Markowits’ the- ory and the impact it has had in the field of financial theory (Berk &DeMarzo, 2020; Mangram, 2013).

The centric part of Markowitz’s model is diversification, also known as the ‘Diversification effect’ and refers to the ‘relationship between correlations and portfolio risk’. Furthermore, diversification is the cornerstone of Markowitz’s portfolio selection theory and modern portfolio theory involving allocating investments to vari- ous financial instruments in different sectors, countries, and security classes. In simple terms, the theory em- phasized by a well-known adage ‘don’t put all your eggs in one basket. The main point of diversification is maximizing returns and minimizing risk by investing in different assets that have different reactions to changes in the world economy. For example, gold and the dollar currency have had a historically negative cor- relation, meaning that the other tends to decrease when one goes up in value. However, the portfolio can be comprised of various assets, and if an imperfect correlation is reached between assets, the portfolio can be said to be the ‘diversification effect’. However, Markowitz’ (1952) raised an important point that diversification cannot eliminate all risks as companies face a systematic risk. Systematic risk is also known as the market risk, which cannot be reduced as it stems from factors like war, inflation, high-interest rates, and recession, which systematically affect most companies (Mangram, 2013). The collective relationship between the assets in the


portfolio can be viewed through the volatility of the whole portfolio that depends on the volatility, or total risk, scaled by its correlation with the portfolio, which adjusts for the fraction of the total risk that is common to the portfolio.’ (Berk & DeMarzo, 2020; Mangram, 2013).

Equation 1

𝑆𝐷(𝑅𝑃) = ∑ 𝑥𝑖∗ 𝑆𝐷(𝑅𝑖) ∗ 𝐶𝑜𝑟𝑟(𝑅𝑖, 𝑅𝑃)



𝑋𝑖 is amount of 𝑖 held, 𝑆𝐷(𝑅𝑖) is total risk of 𝑖,

𝐶𝑜𝑟𝑟(𝑅𝑖, 𝑅𝑝) is fraction of 𝑖’s risk that is common to 𝑃.

Limitations of Markowitz’ theory

Markowitz’ theory did not come without limitations as it showed that ‘not all decision makers can find their preferred investment plans in the expected value-variance set, EV. Furthermore, Tobin (1958) showed the ‘EV set to be efficient for investors with quadratic utility function’ while others showed it to be risk-averse inves- tors only if the outcomes from investment plans were normally distributed. In a nutshell Modern portfolio Theory concludes that index actually represents the optimal portfolio, but it does not take into consideration that ‘not all businesses are worth owning – many businesses do not earn attractive return on their invested cap- ital’. Thus, it is crucial to keep in mind that although it is a great contribution to the understanding of invest- ing, in the end, ‘it is a model of the way the world work and not a literal description of the real world’

(Bleiberg, 2018; Robinson & Brake 1979).

Discounted Cash Flows

When a company seeks to acquire a target company, the indicated firm value of the acquired company can be defined best from the actual merger price negotiated. However, many alternative valuation methods, including discounted cash flow, DCF, are used to estimate its fair market value. It is important to remember that in prac- tice, the fair value is usually a combination of multiple valuation methods, each having its weight (DePamphi- lis, 2020). The core idea of the model is valuing the firm based on the cash flows that it will generate in the future. The DCF, when using unlevered free cash flow, determines the total value to all investors, equity, and debt holders, thus estimating the firm's enterprise value. We can look at the enterprise value as the net cost of


acquiring a company's equity, paying off all debt, and taking its cash, thus owning the unlevered business (Berk & DeMarzo, 2020; Depamphilis, 2019).

Equation 2

𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒 = 𝐸𝑉 = ∑ 𝐹𝐶𝐹

(1 + 𝑊𝐴𝐶𝐶)𝑖+ 𝑇𝑉𝑛 (1 + 𝑊𝐴𝐶𝐶)𝑛




Equation 3

𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 = 𝑇𝑉 = 𝐹𝐶𝐹𝑛+1 (𝑊𝐴𝐶𝐶 − 𝑔)

This leads us to value the enterprise by computing the present value of future cash flows, FCF, that the com- pany has available to pay its debt and equity holders. Thus, as the FCF is attributable to all investors, it is said to be unlevered free cash flow, and it is calculated as follows (Berk & DeMarzo, 2020):

Equation 4

𝐹𝐶𝐹 = 𝐸𝐵𝐼𝑇 − 𝑇𝑎𝑥𝑒𝑠 + 𝐷&𝐴 − 𝐶𝐴𝑃𝐸𝑋 − Δ𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

It is important to remember that free cashflow itself measures the cash generated by the firm before any debt- ors or equity holders are paid. Given all the above, we calculate the enterprise value of the firm followingly:

Equation 5

𝑉0= 𝑃𝑉 (𝐹𝑢𝑡𝑢𝑟𝑒 𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝑜𝑓 𝐹𝑖𝑟𝑚)

The major difference between DCF and some other valuation models is the discount rate. Since we are dis- counting the cash flow for both debtors and equity holders, we used the weighted average cost of capital (WACC). The average cost of capital is what the company should pay its debt and equity holders. However, if the company happens to debt-free instead of using the WACC, we should use the cost of equity as the discount rate, which we would derive using the CAPM. Thus, we can think of WACC as the risk of all the investments of the company. When we have established the WACC for the company, we can now use it to discount the free cash flows up to a certain horizon, typically 5-8 years (Berk & DeMarzo, 2020):

Equation 6

𝑉0= 𝐹𝐶𝐹1

1 + 𝑟𝑤𝑎𝑐𝑐+ 𝐹𝐶𝐹2

(1 + 𝑟𝑤𝑎𝑐𝑐)2+ ⋯ + 𝐹𝐶𝐹𝑁+ 𝑉𝑁 (1 + 𝑟𝑤𝑎𝑐𝑐)𝑁


Additionally, we calculate the terminal value assuming a constant long-term growth rate, that is usually close to the GDP growth rate, and discount it to perpetuity:

Equation 7


𝑟𝑤𝑎𝑐𝑐− 𝑔𝐹𝐶𝐹 = ( 1 + 𝑔𝐹𝐶𝐹

(𝑟𝑤𝑎𝑐𝑐− 𝑔𝐹𝐶𝐹)) ∗ 𝐹𝐶𝐹𝑁

by adding these two numbers we get the enterprise value of the firm. In a real-life scenario this contributes to the decision make of the acquirer to define the price of the company that they are trying to buy (Berk & De- Marzo, 2020).


As touched upon earlier WACC is an important part of the DCF model and has a crucial effect on the com- pany’s enterprise value. We derive WACC followingly (Berk & DeMarzo, 2020):

Equation 8

𝑟𝑤𝑎𝑐𝑐 = 𝐸

𝐸 + 𝐷∗ 𝑟𝐸+ 𝐷

𝐸 + 𝐷∗ 𝑟𝐷∗ (1 − 𝑇𝑐)


𝑟𝑊𝐴𝐶𝐶 is weighted-average cost of capital 𝐸 is value of equity

𝐷 is value of debt

𝑟𝐸 is equity cost of capital 𝑟𝐷 debt cost of capital 𝑇𝑐 is corporate tax rate

As with any investment opportunity, choosing the proper discount rate is crucial since if you choose 'one that is too low overvalues the target and risks overpayment while one that is too high undervalues the target and reduces the likelihood of being able to close the deal'. So not only does the cost of capital hold theoretical im- portance, but it plays a major role in real-life scenarios as well. The drawback with using the WACC in the real world is 'when the acquirer has many lines of business and fails to use the WACC associated with each line of business. Thus, the WACC is very business and leverage ratio specific and has to be explicitly used to a


certain business. Thus, there is no general cost of capital numbers that could be applied to a batch of compa- nies. For example, in a sum of parts type of valuation, where different company divisions are valued separately and summed to define the company's total enterprise value, the business might have as many WACCs as it has a variety of business divisions (Depamphilis, 2019).

Furthermore, WACC is also often used to evaluate the return on invested capital, ROIC, that measures the profitability of the operations of a business. ROIC is calculated as:

Equation 9

𝑅𝑂𝐼𝐶 =𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 (𝑁𝑂𝑃𝐴𝑇) 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑙𝑒𝑠𝑠 𝑑𝑒𝑓𝑓𝑒𝑟𝑒𝑑 𝑡𝑎𝑥 𝑥 100

Furthermore, by subtracting WACC from ROIC, we get Economic Value Added, EVA, which is a measure- ment of a company’s residual performance, thus subtracting WACC and ROIC. A company generates excess returns if ROIC exceeds its WACC. This meaning that even though accounting profits might be positive, it is not proof of value creation, since in order for them to be value-creating, accounting profits, measured as a per- centage of ROIC, exceeds the WACC. ROIC can be a valuable tool in M&A transactions and valuing target companies as it can be used to identify the best performer in the industry. When the companies in question are publicly listed, this kind of ‘analysis provides management with guidance about the market’s outlook of the firm’s future profitability. However, like WACC, ROIC does not come without its pitfalls. It might be affected by the differences in accounting policies, the average age of assets, differences in systematic risks, and product lifecycle. However, it is still a good indicator for the investor and the management of a company of the current market outlook and the level of performance compared to the company’s peers (Plenborg & Kinserdal, 2020)


Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) format started when Jack Treynor (1961) wrote mathematical notes on capital asset pricing and capital budgeting, where he develops a concept to quantify risk and risk relations.

One of his forthcoming conclusions was that the risk in an investment project could be defined as the increase in the sensitivity of the market value of the investing company to the relevant variables and that short-term risk from uninsurable variables is largely the risk from the possibility of changes in the market forecasts of these same variables instead of the uncertainty of future cash flows (Treynor, 1961).

William Sharpe (1964) had his view on market equilibrium and risk. He stated that all efficient combinations would be perfectly correlated and useful in interpreting the asset's expected return and risk. Sharpe also found that the rate of an asset return to the level of economic activity is relevant in assessing its risk as prices adjust to a linear relationship between magnitude and expected return. He demonstrated in his paper that capital as- sets considered individually yield implications with the concepts, as equilibrium conditions in the capital mar- ket have consistent results in the capital market line (Sharpe, 1964).

Closely after John Lintner (1965) introduced his comments and theory, which was an extended view of Sharpe's (1964) papers on that a portfolio must be mean-variance efficient. Lintner's key takeaways were first that stock values will vary directly with both the intercept and the correlation coefficient and always vary in- versely with the residual variance of the regression. The second key takeaway involves the slope coefficients will involve income effects and risk effects. Overall, he showed the theoretical importance of residual vari- ances in selecting optimal portfolios, where the added return on the optimal portfolio will always be compen- sated for the additional risk involved in holding it and therefore always be creating the best diversification.

This aligned with the research done by Jan Mossin (1966) as he shows the theoretical approach of showing the risk compensation per unit of an asset, where the increase in expected yield per unit increases the risk of a unit of the assets (Lintner, 1965; Sharpe, 1964; Mossin, 1966).

The CAPM theory is a framework extension of Markowitz's (1952) portfolio theory of mean-variance optimi- zation and is commonly known as a single index model. To put the theory in practice, it has several underlying assumptions. The first assumption is ‘Investors can buy and sell all securities at competitive market prices with incurring taxes or transaction costs and can borrow and lend at the risk-free interest rate.’. This assump- tion is similar to the theory of the law of one price, as it says if equivalent investment opportunities trade sim- ultaneously in different competitive markets, then they must trade for the same price in all markets (Berk &

DeMarzo, 2020).


The second assumption is that ‘Investors hold only efficient portfolios of traded securities – portfolios that yield the maximum expected return for a given level of volatility’. In other words, that all investors are behav- ing to choose a portfolio of traded securities that gives the highest possible expected return given the level of volatility that the investors are willing to accept. Investors across countries have their own estimates of volatil- ity, correlations, and returns. Still, they all base their forecasts on historical patterns and information, such as market prices, publicly available. Therefore, if all investors use publicly available information, then it's likely that their estimations must be similar. To consider an event where all investors have the same estimates about future investments and returns is known as homogeneous expectations. However, in practice, they will not be completely identical. Still, it will be reasonable to assume homogeneous expectations, which leads to the third and last assumption for CAPM that ‘Investors have homogeneous expectations regarding the volatilities, cor- relations, and expected returns of securities (Berk & DeMarzo, 2020).

If the assumptions for CAPM hold, then the market portfolio is efficient. When the tangent portfolio goes through the market portfolio, it is called the Capital Market Line (CML). CAPM explains to all investors to create a portfolio on the CML by holding some combination of risk-free securities and the market portfolio.

Therefore, the CAPM assumptions lead to identifying the efficient portfolio when it is equal to the market portfolio and finding the expected return with the following formula (Berk & DeMarzo, 2020):

Equation 10

𝐸[𝑅𝑖] = 𝑟𝑖 = 𝑟𝑓+ 𝛽𝑖∗ (𝐸[𝑅𝑀𝑘𝑡] − 𝑟𝑓)

Where the volatility of the asset that is common with the market:

Equation 11

𝛽𝑖 =𝑆𝐷(𝑅𝑖) ∗ 𝐶𝑜𝑟𝑟(𝑅𝑖, 𝑅𝑀𝑘𝑡)

𝑆𝐷(𝑅𝑀𝑘𝑡) =𝐶𝑜𝑣(𝑅𝑖, 𝑅𝑀𝑘𝑡) 𝑉𝑎𝑟(𝑅𝑀𝑘𝑡)

The beta is the measure of identifying the systematic risk and shows the covariance of the asset and the market portfolio divided by the variance of the market portfolio. By assuming the market portfolio is efficient, then changes in the market portfolio will represent the systematic shocks to the economy. Therefore, by calculating the sensitivity of the security’s return to the return of the market portfolio, it will return the systematic risk of this asset, also known as the beta of the security. The interpretation of beta of a security is the expected percent change in its return given a one percent change of the market portfolio, where the average beta of stock in the market is one. However, this may vary for companies in different industries and business cycles that are more


sensitive to the systematic risk and will have a beta above one. Business who is less sensitive will then have a beta below one (Berk & DeMarzo, 2020.)

The beta values relationship with the CAPM is to adjust the market risk premium, so it needs the investors’

risk premium that the investors require to make the risky investments. As if beta equals one, the market risk premium represents that the investors expect a risk-reward equal to the market premium, and if it is above one, then the investors require a larger expected return compared to the market risk premium. Since the model for CAPM is calculating for one period, which indicates that the beta value can differ in time, but when it is calcu- lated for a combined portfolio, it is calculating the weighted average of betas that is underlying in the given portfolio. If the beta value is negative, then there is a negative market risk premium, which creates an expected return below the market risk premium. Thus the securities containing a negative beta value tend to be perform- ing well in bad economic times (Berk & DeMarzo, 2020; Munk, 2013).

Critique of CAPM

CAPM does come without its pitfalls. It is unrealistic to assume that all information is available to all investors resulting in homogenous expectations. Furthermore, finding a value for the Equity risk premium is more com- plicated as the return on a stock market is the sum of the average capital gain and the average dividend yield.

Thus, ‘In the short term, a stock market can provide a negative rather than a positive return if the effect of fall- ing share price out weights the dividend yield. CAPM can present some pitfalls when used in, for example, in the DCF model, as ‘problems can arise when using the CAPM to calculate a project-specific discount rate.’

(Head, 2008).

One aspect of the problem stems from finding common proxy betas for calculating specific discount rates.

This is due to companies usually undertaking more than one business activity. Thus, un-levering the beta and then levering it back to the company’s capital structure might showcase some issues as well. Comparable com- panies might use betas that may use capital structure information that is not available, affecting the un-levering and the further affecting as well once levered back to represent our target company’s beta. Furthermore, as- suming that the beta of debt is risk-free is misleading (Head, 2008).

Although the beta is small, it still not zero affecting our calculations on the cost of equity. There is a plethora of critique about the CAPM, and to get a better overview of the most substantial critique of the model, here are some of the gathered pitfalls (Fard & Falah, 2015):

1. CAPM assumes a stock return has a normal distribution, but it seems like the distribution is not nor- mal.


2. CAPM assumes variance of the returns equals risk.

3. CAPM does not reveal the variance of stocks as much as it should.

4. CAPM assumes investors prefer lower risk to higher risk when facing a specific expected rate of re- turn.

5. CAPM assumes investors have access to equal information and agree with each other about risk and return of all stocks.

6. CAPM assumes there is no taxes and transaction cost.

7. Market portfolio includes all the securities in all the markets while every single security has its spe- cific weight on the market.

8. Theoretically, market portfolio includes all the securities kept as capital asset, but in practice, it is re- placed by stock indexes.

9. The model that evaluate a stock according to the price of all the other stocks is in fact an arbitrage model which has no clearance on how the stock beta is determined.

10. Because the combination of market portfolio is not known, CAPM is not applicable.

Despite the model’s pitfalls, it is still one of the valuable models as most of the other theories, such as Mer- ton’s (1937) I-CAPM and Arbitrage Pricing theory, demand such costly information compared to the CAPM (Fard & Falah, 2015). However, ‘the practical success of this approach strongly depends on successfully cap- turing the time-variation betas’ (Fard & Falah, 2015).

However, Munk (2013) describes a few aspects where the CAPM is insufficient. First of the single period de- riving of the expected return, as it meets unrealistic assumption that demand and supply of agents living for more than one period are the same in all periods and that CAPM is not functional to capture variations in the security’s price over time. On the statistical part, the CAPM assume that all asset returns over the period are normally distributed, which goes against the fact that investors cannot lose more than what they have invested, which means that it cannot go below -100%, as this is inconsistent with a normal distribution that associates a positive probability to any return. This is supported by empirical studies that show for many assets that the normal distribution is not a good approximation of the return distribution (Munk, 2013).

Taking macroeconomics into consideration, the CAPM model does not create an insight into any links be- tween financial markets and macroeconomic variables such as consumption, production, and inflation. The model doesn’t explain the return of the risk-free asset or the return of the market portfolio (Munk, 2013).


Fama French Multi Factor model

In addition to Markowitz (1959) and the later additions to optimal portfolio theory, Fama and French (1992) created a multi-factor CAPM model known as the cross-section of expected stock returns. They expand the single regressor CAPM formula by adding size risk and value risk factors to the market risk factor in CAPM.

This addition considers that values of small-capitalization stocks are outperforming the market. This gives the model an adjustment for the tendency and creates a better evaluating tool for investors (Fama & French, 1992).

The model has three factors size of firms, the book to market values, and the excess return on the market. The size of the firm’s factor is known as Small Minus Big (SMB). They take the return on a portfolio of small companies based on their market capitalization minus the return of a portfolio of the big companies. The sec- ond new factor is the High Minus Low (HML) which is the return of a portfolio of companies with a high book to market value minus the return of a portfolio of companies with a low book to market value (Fama French, 1992; Munk 2013).

Figure 2: Illustration of Fama French Multifactor Portfolios

(Authors’ own creation, 2021).

When categorizing the companies into small or large based on market capitalization, all securities in the port- folio are ranked by their market capitalization. In contrast, companies with a higher market capitalization value than the median value will be categorized as companies with large capitalization. Those who have a lower market capitalization than the median value will be categorized as small companies. While determining the High Minus Low portfolios, it is based on their book to market value, classifying the companies by saying that companies under the 30th percentile of the portfolios book to market value are named growth stocks. In between the 30th- and the 70th percentile of the portfolios book to market value is the Neutral stocks. In con- trast, the last companies above the 70th percentile are categorized as the Value stocks (Fama & French, 1992).

The table above gives a visual understanding of how the portfolio's securities are divided into six different sub-portfolios. Whereas to calculate the average monthly excess return on SMB is as follows:

70th percentile B/M Small Value Big Value

30th percentile B/M Small Neutral Big Neutral

Small Growth Big Growth

Median Market Capitalization


Equation 12

𝑆𝑀𝐵 = (1

3∗ (𝑆𝑚𝑎𝑙𝑙 𝑉𝑎𝑙𝑢𝑒 + 𝑆𝑚𝑎𝑙𝑙 𝑁𝑒𝑢𝑡𝑟𝑎𝑙 + 𝑆𝑚𝑎𝑙𝑙 𝐺𝑟𝑜𝑤𝑡ℎ))

− (1

3∗ (𝐵𝑖𝑔 𝑉𝑎𝑙𝑢𝑒 + 𝐵𝑖𝑔 𝑁𝑒𝑢𝑡𝑟𝑎𝑙 + 𝐵𝑖𝑔 𝐺𝑟𝑜𝑤𝑡ℎ))

Where to calculate the average monthly excess return on the HML is as follows:

Equation 13

𝐻𝑀𝐿 = (1

2∗ (𝑆𝑚𝑎𝑙𝑙 𝑉𝑎𝑙𝑢𝑒 + 𝐵𝑖𝑔 𝑉𝑎𝑙𝑢𝑒)) − (1

2∗ (𝑆𝑚𝑎𝑙𝑙 𝐺𝑟𝑜𝑤𝑡ℎ + 𝐵𝑖𝑔 𝐺𝑟𝑜𝑤𝑡ℎ))

The overall Fama French multi factor formula will therefore be:

Equation 14

𝑟𝑖− 𝑟𝑓 = 𝛼𝑖+ 𝛽𝑖,𝑀𝑘𝑡∗ (𝑟𝑀𝑘𝑡− 𝑟𝑓) + 𝛽𝑖,𝑆𝑀𝐵∗ 𝑆𝑀𝐵 + 𝛽𝑖,𝐻𝑀𝐿∗ 𝐻𝑀𝐿 + εi

Carhart Four Factor Model

In addition to the Fama French three-factor model Carhart (1997) proposed a new variable to the regression making it into a four-factor model:

Equation 15

𝑟𝑖− 𝑟𝑓 = 𝛼 + 𝛽𝑖,𝑀𝑘𝑡∗ (𝑟𝑀𝑘𝑡− 𝑟𝑓) + 𝛽𝑖,𝑆𝑀𝐵∗ 𝑆𝑀𝐵 + 𝛽𝑖,𝐻𝑀𝐿∗ 𝐻𝑀𝐿 + 𝛽𝑖,𝑊𝑀𝐿∗ 𝑊𝑀𝐿

His paper is indicated the findings of Jegadeesh and Titman (1993) of one-year momentum in stock returns accounts for Hendricks et al. (1993) hot hands effect in mutual fund performance, referring to the basketball phrase as a player have 'hot hands' after a streak of good results and therefore more likely to score again next time. The constructed formula is the Fama French three-factor model with Jegadeesh's and Titman's (1993) factor of one-year momentum anomaly. It is the one-year momentum stocks versus contrarian stocks, also specified as Winners Minus Losers (WML). This four-factor model explains variation in returns and improves the average pricing errors of the CAPM and Fama French three-factor model. It eliminates almost all of the patterns in pricing errors, which indicates that this model is describing the cross-sectional variation in average stock returns well (Carhart, 1997; Jegadeesh & Titman, 1993; Hendricks et al., 1993).



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