Misvaluation and ESG

“We feel that sustainability should be our new investing benchmark” (BlackRock, 2020). Larry Fink, Chairman of the world’s largest asset management firm, promises “a majorreallocation of money” based on sustainability criteria in his 2020 annual letter to clients (BlackRock, 2020). According to the Global Sustainable Investment Review (GSIA, 2018),the increase of sustainable investing is a global trend. In the United States, sustainable investment has grown by 42 percent since 2018, with more than one-third of professionally managed assets — $17.1 trillion in total — being invested in line with sustainability standards (USSIF, 2020). While ESG is already a hot subject among politicians, institutional investors, and corporations, it is rapidly becoming a factor in individual individuals’ investing decisions. Mutual funds with a higher given sustainability rating, for example, enjoy significant net inflows, whereas mutual funds with a lower assigned sustainability rating experience outflows (Hartzmark and Sussman, 2019). The international trend to embrace ESG principles, accompanied by regulatory initiatives, boosts demand for high ESG-rated firms. Simultaneously, the screening procedure based on ESG principles decreases the number of possible investment options (e.g. Ghoul and Karoui, 2017; Hoepner, 2017). As a result, rising demand for sustainable enterprises, along with a restricted investment universe, may have an impact on the market price efficiency of these organizations. In this blog, we look at whether ESG causes possible business misvaluation and, as a result, impacts market efficiency. While sustainable investment raises immediate concerns about financial performance (e.g., Hong and Kacperczyk, 2009; Barber et al., 2021; Galema et al.,2008), I am especially concerned in the implications of sustainable investing for stock market value. I discover that ESG has a considerable impact on the misvaluation of US businesses. Improved corporate sustainability, in particular, raises a company’s market valuation relative to its real worth. An examination of overvalued and undervalued businesses indicates that ESG causes increased overvaluation and decreases current undervaluation. Furthermore, I realize that information asymmetry does not appear to play a role in the link between ESG and misvaluation.

Furthermore, the ESG-misvaluation link has grown stronger in recent years, and it appears tobe mitigated by the increased importance of CSR. This importance is mirrored in sentiment toward sustainability topics: the larger the influence of ESG on misvaluation metrics, the higher the ESG market sentiment, i.e. societal and investor awareness of sustainability standards.

My empirical method for determining the influence of ESG on business valuation is simple: Icame across explored links between a company’s sustainability profile (as defined by ASSET4’sESG score) and its misvaluation using the sample of 1,817 US companies. As a result, I understand the business misvaluation by estimating a company’s intrinsic equity value, whichI then compare to the actual observed value. I observe two distinct misvaluation metrics that have been well-established in the literature (e.g., Dong et al., 2020; Fu et al., 2013). First, I look at a metric that is based on I/B/E/S earnings projections of a company’s future profits per share and is based on Ohlson’s residual income model (1995). The second metric proposed by Rhodes-Kropf et al. (2005) is based on accounting data. The use of two separate techniques to capture misvaluation emphasizes the robustness of my findings, as they look at misvaluation from various angles. Furthermore, the findings of multiple two-stage least squares instrumental variable regressions, as well as dynamic panel Generalized Method of Moments (GMM) estimates, show that the link between ESG and misvaluation is resistant to possible endogeneity issues. Furthermore, the results are resilient to an alternate way of measuring ESG performance of enterprises independent of a numerical score: inclusion in the MSCI KLD 400 Social sustainability index resulted in greater misvaluation ratios for the relevant companies. The contribution to literature from this study is as follows: First, it is demonstrated that ESG influences misvaluation in a large sample of US companies by analyzing the direct relationship between ESG and misvaluation. This builds on the findings of Cao et al. (2021), who analyze socially responsible institutions’ investment decisions depending on current levels of CSR and misvaluation of possible investment targets. Their findings, however, do not show a direct relationship between CSR and misvaluation, but instead explicitly evaluate the overall influence on stock returns.

Second, the research delves deeper into the topic of how ESG influences current over- and undervaluation. It is discovered that, regardless of the amount of business misvaluation currently in place, ESG initiatives result in greater valuation as compared to the firm’s real worth. As a result, a recent body of research is added suggesting that sustainable investing changes traditional investment criteria and behavior (Riedl and Smeets, 2017; Gutsche and Ziegler, 2019). Socially responsible investors base their investment decisions on their ESG preferences, attributing company value to the CSR profile of higher ESG-rated businesses, which may result in significant capital flows towards more sustainable investment targets (Hartzmark and Sussman, 2019; Bialkowski and Starks, 2016). Furthermore, these data support the stakeholder theory’s thesis (Freeman, 1984) that CSR initiatives do not reduce shareholder wealth but may have positive value consequences (Deng et al., 2013). The findings do not support the shareholder value maximization approach (Friedman, 1970), which contends that CSR expenditures are linked with costs with no direct return (Cronqvist et al., 2009) and hence regarded as less favorable by shareholders.

Another body of evidence suggests that CSR has a beneficial influence on stock pricing efficiency owing to increased information availability (Cui et al., 2018; Lopatta et al., 2015; Siew et al., 2016). However, this moderating impact of information asymmetry in the ESGmisvaluation connection is not observed, it is infered that a company’s excellent CSR performance encourages (sustainable) investors to regard these businesses as appealing investment possibilities. This impact may encourage capital movements, causing overvalued enterprises to increase their overvaluation and undervalued firms to converge to their real worth.

Third, there is addition to an area of the ESG literature that focuses on the function of emotion (e.g., Choi et al., 2020; Brgger and Kronies, 2021). It demonstrate that sentiment is especially important in the case of misvaluation since higher attitude toward sustainability enhances the influence of ESG on firm misvaluation.

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