Environmental, Social, and Governance Investment and Material Disclosure by Companies

Abstract

Although institutional investors have generally used the discounted cash flow method (DCF method) in their valuation processes, it has become essential to enhance valuation precision for an extended period by applying the appropriate discount rate as a denominator and future cash flows as a numerator. We examine the relationships between WACC (weighted average cost of capital), which is generally used as a discount rate in the DCF methods in business, and ESG (Environmental, Social, and Governance) score to incorporate ESG issues into the mid-to-long term valuation process. We observe a negative relationship that is statistically significant between environmental score, evaluated based on degree of disclosure, and the WACC. We also observe negative relationships between environmental, social, and governance scores in a group with high firm-specific information (with high unsystematic risk) and the WACC. These results suggest that the value of companies with a high degree of disclosure of ESG could be high. We propose that investors should use a discount rate adjusted by ESG in their valuation processes, and companies should disclose ESG risks and opportunities, which they recognize, and use countermeasures so that investors can enhance mid-to-long term valuation precision.