Is Being A “Good” Company Worth It?

Is Being A “Good” Company Worth It?
Reda Farran, CFA

over 2 years ago5 mins

  • Companies are under pressure to be better corporate citizens, with the promise of higher company valuations if they do good.

  • In theory, good companies should benefit from higher valuations due to higher revenue growth, profit margins, and investment efficiency, as well as lower risk.

  • In practice, the evidence is very mixed with a stronger argument for companies to avoid being bad than to try to be good.

Companies are under pressure to be better corporate citizens, with the promise of higher company valuations if they do good.

In theory, good companies should benefit from higher valuations due to higher revenue growth, profit margins, and investment efficiency, as well as lower risk.

In practice, the evidence is very mixed with a stronger argument for companies to avoid being bad than to try to be good.

Companies are increasingly bending over backwards to let you know how “good” they are, and they’re using the promise of higher valuations to persuade you to jump on board. But rather than take their marketing spiel at face value, I want to look into how environmental responsibility and social consciousness could lead to a better valuation – as well as if there’s actually any proof they actually do.

First of all, what drives company value?

Before looking at the relationship between social responsibility and value, we need to understand what drives company value in the first place.

In its simplest form, 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.

Equation to calculate the value of a company. Source: Damodaran
Equation to calculate the value of a company. Source: Damodaran

Digging deeper into this equation, valuation guru Aswath Damodaran has used it to create a great framework that allows us to first identify key value drivers, and then assess how those drivers are affected when companies try to be good. We’ll get onto the latter shortly, so let’s take a look at the drivers first:

  • 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 of these drivers are relatively straightforward to understand. As for investment efficiency, just know that in order for companies to grow revenues, they need to invest in things like 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. Under this framework, risk has two dimensions. First, the operating risk of the business. This is basically the uncertainty around the firm’s future cash flows and is 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 also the risk that the company will not survive as a going concern. This is called risk of failure, with a higher risk of failure leading to lower company value.

Don’t worry so much about how any of these are calculated: what’s important is that you understand the intuition behind what drives company value.

How does being a “good” company impact company value?

First, it’s important to understand that trying to measure the relationship between company valuation and company integrity is very difficult for two reasons. For starters, there’s no standard or objective way to measure what’s considered a “good” company. And then there’s the issue of causality: does being good lead to higher company valuations, or do financially sound companies with high valuations simply have the resources to invest in being more socially responsible and environmentally conscious?

With that caveat out of the way, Damodaran’s looked at how the above value drivers relate to being a “good company”, and he’s noticed that being more socially responsible and environmentally conscious can theoretically lead to higher company valuations thanks to a virtuous cycle. You can see that cycle below:

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

Essentially, customers who are attracted by a company’s social mission might favor its products over its competitors, allowing it to gain market share and grow revenue. But a company trying to be good will also initially see its profit margin shrink due to added costs – higher wages and employee benefits, sourcing materials from responsible suppliers, and so on. Then again, higher revenues lead to economies of scale which could actually leave those profit margins unchanged or higher – good companies, for example, could see lower regulatory and legal costs in the future. Faster revenue growth and higher profit margins mean the 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, lowering their cost of debt. Taken together, good companies have lower costs of capital which increases their value. What’s more, good companies also benefit from higher valuations due to lower failure risks. 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 in the long run.

All these factors work in reverse too: a bad company can end up with a lower valuation due to 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
The punishment for being bad. Source: Damodaran

What does the evidence say?

The above framework sounds logical and suggests that good companies should benefit from higher valuations, but in practice the evidence is mixed.

There’s little supporting evidence that good companies have higher revenue growth, profit margins, or investment efficiency. But there is some (weak) evidence to suggest that they have lower costs of capital, which slightly increases their valuations. There’s also some evidence suggesting that bad companies are punished by the market or customers for being bad, leading to slightly lower valuations. That could also be because these companies expose themselves to greater reputational or disaster risks, leading to higher risks of failure in the framework we discussed.

What this means in practice is that there’s less of an argument for companies to be good (because they won’t be rewarded with higher valuations) than for companies to avoid being bad (because they will be punished). And from a financial point of view, that doesn’t spell good news for corporate management teams plowing loads of money into social responsibility and eco-consciousness…

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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