Good As Gold: Here's Whether Responsible Firms Can Really Cash In On Kindness

Companies are increasingly bending over backward to let you know how “good” they are – and because a feel-good factor just isn’t enough for investors, they’re leaning on the idea that their good deeds will be rewarded with higher valuations. But you never want to take a company’s marketing spiel at face value. So let’s look into how the virtues of environmental responsibility and social consciousness could lead to a better valuation – and see if there’s any proof they actually do.

First of all, what drives company value?

Before we get to social responsibility, let’s remind ourselves about what drives a company’s value in the first place. Simply put, the value of a company is the sum of all its expected future cash flows, discounted back to today at a rate that reflects the riskiness of the company.

This equation calculates the value of a company. Source: Aswath Damodaran.

Valuation guru Aswath Damodaran took that formula a step further, using it to create a framework that can help you identify key value drivers – and soon, we’ll use it to assess how they change when companies try to be do-gooders. Check out the factors:

• Revenue growth (faster = higher company valuation)
• Profit margin (bigger = higher company valuation)
• Riskiness (lower = higher company valuation)
• Investment efficiency (better = higher company valuation)

The first three are relatively simple to understand. As for the fourth one, investment efficiency, just know that for companies to pull revenue up, they need to invest in equipment, software, research and development, raw materials, and so on. Companies that are more “investment efficient” generate more revenue for every dollar of capital they invest, and they’re rewarded with higher valuations.

One last thing to keep in mind: under this framework, risk has two dimensions. First, there’s the operating risk of the business. That’s basically how certain or uncertain the firm’s future cash flows are, captured by the company’s “cost of capital” (which is also the rate used to discount those cash flows to the present). A higher cost of capital leads to lower company value. Second, there’s the risk of failure: the odds that a company won’t survive. As you might’ve guessed, the higher the risk of failure, the lower the company’s value.

Don’t worry about the ins and outs of how these are calculated: what matters is that you understand the logic behind company value.

How does being a good company impact company value?

Just like there’s no medical test that can tell a decent human from a devilish one, there’s no standard or objective way to measure how “good” a company is. And that means the relationship between company valuation and company integrity is hard to measure, especially given the issue of causality. Being good might lead to higher company valuations, but maybe financially sound companies with high valuations simply have the resources to invest in socially responsible and environmentally conscious initiatives.

Well, when Damodaran assessed how the big four value drivers relate to being a good company, he noticed that a “virtuous cycle” may be pushing more socially responsible and environmentally conscious companies toward higher company valuations. Take a look:

The payoff of being “good”. Source: Damodaran.

Customers attracted to a company’s social mission might favor its products over its competitors, giving the company a shot at gaining market share and growing revenue. A do-gooder will also initially shrink its profit margin by forking out on non-essential costs: higher wages and employee benefit costs, pricier materials sourced from responsible suppliers, and so on. But in time, more revenue leads to economies of scale (when mass production becomes very efficient), which could leave those profit margins unchanged or even push them higher. Plus, responsible firms could see lower regulatory and legal costs in the future. Faster revenue growth and higher profit margins mean a company can generate more profit for every dollar of capital invested, which leads to higher investment efficiency.

Finally, investors prefer to invest in good companies, pushing up their stock prices and lowering their cost of equity. Similarly, lenders will lend at lower interest rates to good companies as they seem less risky, lowering their cost of debt. Pop that in a formula, and good companies emerge with lower costs of capital – and that increases their value. What’s more, good companies have lower failure risks, a plus for their valuations. A renewable energy company, for example, arguably has a lower risk of failure stemming from a big scandal or catastrophic event than an oil firm. It also has a better chance of survival in the long run as governments phase out fossil fuels in favor of green energy.

Bear in mind, all these factors work in reverse too: a “bad” company can end up with a lower valuation because of lower revenue growth, profit margins, and investment efficiency, as well as higher risk. You can see this in the diagram below:

The punishment for being “bad”. Source: Damodaran.

So do good companies do better, or not?

The Damodaran framework’s suggestion that good companies should benefit from higher valuations sounds logical, but the evidence is mixed.

There are few facts to prove that good companies have higher revenue growth, fatter profit margins, or better investment efficiency. But there is some (admittedly weak) evidence to suggest that they have lower costs of capital, and that does slightly increase their valuations. There’s also some weight behind the suggestion that bad companies are punished by the market and customers for, well, being bad, and that does slightly decrease their valuations. And since those companies also could suffer from greater exposure to reputational or disaster risks, they may have a higher chance of failure, according to the framework.

In practice, that means there’s less reason for companies to do good because they likely won’t be rewarded with higher valuations (for now at least). Rather, they should just avoid being bad, as those firms are more likely to be punished. From a financial point of view, that won’t go down well with the corporate management teams who are plowing loads of money into social responsibility and eco-consciousness.