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0 Tools for Valuing Business Sustainability Prepared for: The Research Network for Business Sustainability By: Dr. John Peloza, Simon Fraser University.

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Presentation on theme: "0 Tools for Valuing Business Sustainability Prepared for: The Research Network for Business Sustainability By: Dr. John Peloza, Simon Fraser University."— Presentation transcript:

1 0 Tools for Valuing Business Sustainability Prepared for: The Research Network for Business Sustainability By: Dr. John Peloza, Simon Fraser University and Mr. Ron Yachnin, Yachnin & Associates

2 1 Research Question Identify the business tools with which managers can value the business case for sustainability. In which contexts have these tools been applied? What are the collective results?

3 2 Motivation Move beyond the rhetoric Hard measures for the CFO

4 3 Systematic Review Criteria for Inclusion –Quantitative calculation of business value or process for calculating it Time –Academic – all time periods –Practitioner – 2001+

5 4 Results

6 5 Stages of Metrics Sustainability Initiative Environmental Social

7 6 Results How sustainability is measured matters: –Environmental sustainability = 65% positive correlation to financial performance –Social sustainability = 55% positive

8 7 Sustainability Metrics How sustainability is measured matters: –Environmental sustainability = 65% positive –Social sustainability = 55% positive Some are outright negative: –South Africa (75% negative) –Mutual fund screens (45% negative)

9 8 Stages of Metrics Sustainability Initiative Environmental Social End State Outcome Metrics

10 9 Included in 91% of all observations Most common: –Share price (78) –ROA (26) –ROE (23)

11 10 Results Accounting measures more positive (causality?)

12 11 Stages of Metrics Sustainability Initiative Environmental Social End State Outcome Metrics Market (e.g., share price) Accounting (e.g., ROA) Intermediate Outcome Metrics

13 12 Intermediate Outcome Metrics Relatively rare (included in 16% of studies) Only 9% included both an intermediate and end state measure Most common: –Changes in cost (13) –Cash flow (12)

14 13 Stages of Metrics Sustainability Initiative Environmental Social End State Outcome Metrics Market (e.g., share price) Accounting (e.g., ROA) Intermediate Outcome Metrics Cost changes, revenue increases, cash flow Mediating Metrics

15 14 Mediating Metrics Extremely rare (used in 8% of all studies) Only 3 included consideration of mediation, intermediate and end state metrics –Epstein and Roy (2001) –sdEffect (2006) –JP Morgan (2006)

16 15 Mediating Metrics Extremely rare (8% of studies) When mediation is considered: –Employee related –Cultural innovation –Input/output –Reputation related Most mediation is considered at the conceptual level (versus empirical)

17 16 Mediating Metrics Very little sector specific work, more than half coming from practitioners

18 17 Mediating Metrics Is access to data an issue? –Mediation is examined extensively in the academic literature but rarely with financial outcomes attached –Internal measures such as cash flow are used more extensively in the practitioner literature (11 out of 31, versus 1 out of 129 in academic)

19 18 Practitioner Tools Some examples

20 19 3 Examples SAM and World Resources Institute –Changing Drivers. The Impact of Climate Change on Competitiveness and Value Creation in the Automotive Industry, 2003 Citigroup –Towards Sustainable Mining. Riding With the Cowboys or Hanging with the Sheriff, 2006 Yachnin & Associates, Sustainable Investment Group Ltd. and Corporate Knights Inc. –Translating Sustainable Development into Financial Valuation Measures, 2006

21 20 SAM and World Resources Institute Changing Drivers. The Impact of Climate Change on Competitiveness and Value Creation in the Automotive Industry, 2003

22 21 Authors (Organizational) SAM Sustainable Asset Management –A Zurich based independent asset management company specializing in sustainability-driven investments –Key player in Dow Jones Sustainability Indexes World Resources Institute –A Washington, DC based environmental research and policy organization SAM/WRI

23 22 Purpose to help investors make better informed decisions regarding automotive company stocks in light of emerging carbon constraints – policy measures designed to mitigate climate change by limiting emissions of carbon dioxide (CO 2 ) and other greenhouse gases Carbon constraints could affect some of the industrys traditional value drivers (e.g. costs and innovative capacity) and alter competitive balance SAM/WRI

24 23 Focus 10 leading automobile original equipment manufacturers (OEMs) –BMW, Daimler Chrysler (DC), Ford, GM, Honda, Nissan, PSA Peugeot Citroen, Renault, Toyota and VW Group (US, EU, JP) SAM/WRI

25 24 Approach – 3 Steps 1.Quantify the risks associated with emerging carbon constraints in a measure of Value Exposure 2.Quantify the related opportunities in a measure ofManagement Quality 3.Aggregate cost estimates and management scores and express them as discounted EBIT forecasts (Earnings Before Interest and Taxes) SAM/WRI

26 25 Step 1 Value Exposure Assessment Ask –What costs do OEMs face in meeting higher fuel economy standards in 2015, given their initial sales levels + vehicle mix? Recognize –The costs incurred by each OEM will vary depending on its product portfolio and the current sales-weighted average fuel economy of its fleet, and on the costs of achieving CO2 reductions for different vehicle types Calculate/Model –The lowest-cost combination of technologies each OEM must add to its existing fleet to meet new standards (measure: additional costs per vehicle) (Key factors: 2002 sales/fuel economy + access to incremental technologies, diesel + hybrid technology) SAM/WRI

27 26 Step 2 Mgmt. Quality Assessment Ask –Which OEMs have the strongest potential to capitalize on their investments in lower-carbon technologies and so benefit from carbon constraints? Recognize –OEMs ability to capitalize on carbon constraints depends on a wide range of management attributes regarding lower-carbon technologies – not just technological development capabilities Calculate/Model –Management quality using modified competence model developed by SAM Research (measure: SAM score 1-100) (key factor: positioning relative to ability to capitalize on various carbon technologies) SAM/WRI

28 27 Step 3 Results + Implications for Valuation Aggregate –Risks and upside strategy opportunities Differentiate –among companies in terms of their positioning Assess –implications for valuation by expressing in terms of discounted EBIT forecasts SAM/WRI

29 28 SAM/WRI e.g. Honda – lowest value exposure because of high fleet efficiency e.g. Toyota – highest management quality because of strong position in technologies

30 29 Step 3 Results + Implications for Valuation EBIT a foundation for valuation estimates in the auto sector Changes in an OEMs EBIT offer useful insights into possible changes for overall return on invested capital and thus shareholder value Converting cost estimates and management quality scores into EBIT figures sets results in context of business performance/financial position SAM/WRI

31 30 Step 3 Results + Implications for Valuation Translation – Value Exposure –Carbon related costs ($) will increase the costs of goods sold and so reduce EBIT –VE costs integrated into baseline EBIT forecasts –Changes the rankings of companies relative to cost only rankings e.g. BMW improves markedly – highest costs to meet carbon constraints, luxury brand has higher than average price margins and better ability to tolerate cost increases ensures that the EBIT implications of its value exposure are less damaging than the cost-only figures would suggest SAM/WRI

32 31 Step 3 Results + Implications for Valuation Translation – Management Quality Assessment –Extensively studied but difficult to integrate into valuation models – permeates balance sheet –Possible impacts on a number of financial variables, including increases in EBIT margin, ROIC and sales – magnitude difficult to measure –To integrate MQA scores assumes OEM with the strongest management quality (i.e., Toyota) would see its projected EBIT margin increase by 20 percent, while the OEM with the weakest management quality (i.e., PSA) would see no increase SAM/WRI

33 32 SAM/WRI Upper limit = MQA alone, Lower limit = VEA alone, Point = combined impact of both assessments Range from +8% for Toyota to -10% for Ford Significant upside effect

34 33 Citigroup Global Markets Towards Sustainable Mining. Riding With the Cowboys or Hanging with the Sheriff, 2006

35 34 Author Citigroup –A major New York headquartered financial services company –Among the largest companies in the world –Currently operates as Citi Global Markets/Mining Group –Brokerage and investment analysis in the mining sector Citigroup

36 35 Purpose For the mining sector: –To show that the five factors that make up sustainable development (SD) will affect long-term shareholder value and that those companies which are reacting most effectively to these challenges are likely to outperform –To make investment recommendations based on sustainability-oriented analysis Citigroup

37 36 Purpose Sustainable development in the mining sector presents companies with a number of choices –Seek out low-regulation, low-cost environments for their future development – riding with the cowboys –Develop a new business model that places a premium on environmental responsibility and social progress – hanging with the sheriff –Try to operate in the old way in the new world and go out of business – going to jail Citigroup

38 37 Focus 17 large mining and metals companies –Rio Tinto, BHP Billiton, Anglo-American, Alumina Ltd., Alcoa, Newcrest, Lonmin, Xstrata, AngloGold Ashanti, Impala Platinum, Anglo Platinum, Lihir Gold, Antofagasta, Vedanta, Norilisk Nickel, CVRD, Kazakhmys 2006 Citigroup

39 38 Approach – 4 Steps 1.Sets out the five factors of SD Citigroup considers have the potential to add or destroy value for mining and metals companies globally 2.Develops a Sustainable Mining Index to identify those companies best positioned to create (or destroy) value based on their sustainability profile 3.Calculates alternative risk-adjusted discount rates based on a companys integration of sustainability- related risk/valuation impacts 4.Makes investment recommendations in favour of specific companies (and in disfavour of others) based on this analysis Citigroup

40 39 Step 1 – Five Factors of SD Citigroup See handout

41 40 Citigroup Step 2 – Mining Index See handout Most companies perform well on Commodity Exposure and Country- Specific-Exposure The bulk of the variation is on company-specific Factors such as Mine Development, HSE in Operations and Sustainable Governance

42 41 Step 3- Risk Adjusted Discount Rates Citigroup Winners and best bets are large, diversified companies = valuation upside of 23% to 30% Traditional valuation based largely on country-specific exposure and bond indexes Scenario analysis based on mining index builds in additional company-specific factors

43 42 Step 4 Investment Recommendations Citigroup sees largest upside to valuation occurring for the large diversified mining companies such as Anglo American, BHP Billiton, and Rio Tinto – 23%-30% Generally platinum companies show valuation upside while gold companies show downside On this basis Citigroup recommends buying stand out companies BHP Billiton, Anglo American, Alcoa Inc together with risk adjusted upside in Lonmin and Impala Platinum; and selling Kazakhmys Citigroup

44 43 The sdEffect The sdEffect TM – Translating Sustainable Development into Financial Valuation Measures, 2006

45 44 Authors Yachnin & Associates –Ottawa/Toronto based management consulting company Sustainable Investment Group Ltd. –Toronto based consulting company Corporate Knights –Toronto based media organization sdEffect

46 45 Purpose To translate the impact of specific corporate sustainability initiatives into financial valuation measures so that additive value (+/-): –can be demonstrated in financial terms that are familiar to and easily used by all representatives of the financial/investment community; high level integration into workings of marketplace, address externalities –can be measured, reported, compared, communicated, and… invested in in the same way as other business elements sdEffect

47 46 Focus Five Canadian mining companies –Alcan –INCO –Noranda/Falconbridge –Placer Dome –Teck Cominco 2006 sdEffect

48 47 Approach SD measures from sustainability reports Five valuation techniques –Ratio Analysis –Discounted Cash Flow (DCF) Analysis –Economic Value-Added (EVA) Analysis –Rules of Thumb –Option Pricing 10 calculations (7 SD measures) of The sdEffect on overall company valuation + share price (3 environmental, 2 social, 2 economic) sdEffect

49 48 e.g. INCO Solid Waste Diversion Non-hazardous solid waste is diverted from municipal landfill to company- managed tailings disposal area –Cost savings = $2.4 million per year –DCF value = $31 million Equivalent to $0.16 per share value –P/CF value = $0.06-$0.08 per share sdEffect

50 49 e.g. Placer Dome Community Involvement Programs Community involvement and investment allow fast-tracking of expansions and permitting of new projects –Large projected fast-tracked by 1-year –DCF value of early start = $337 million Equivalent to $0.81 per share value 5.5% equity value lift sdEffect

51 50 Conclusions Measure where impacts are expected Environmental sustainability Social sustainability

52 51 Conclusions Research only recently considering company/firm and initiative level measures –Useful to take us beyond the generic business case argument –Mediation measures required for causality and comparison between initiatives

53 52 Conclusions What do we really know about the business case? –Causality not addressed –Are measures comparable? Need to move beyond the generic business case to specific initiatives, structures and processes to examine business case at firm and initiative levels.

54 53 Where Do We Go From Here? Increased use of mediation metrics, and inclusion of all 3 types within the same case study. More company/firm initiative specific measures are needed - collaboration between practitioners and academics. Matching access to data with measurement and modelling expertise. Consistency among sustainability measures. ISO? Classification of effects?


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