How to maintain the right balance between shareholder value creation and sustainability?

Ayush Jha

25th July 2022

 


The core principles of economics suggest that a business’ prime motive should be to create profit. Shareholders value their stake in the company based on quarterly performances and the amount of profit created is the first thing on their agenda. A shareholder determines the growth in an organization based on the increase in value of their shares from the time they put in the initial investment. 

 

For instance, if shareholder A invested $Y in 2015, then they would expect the company to have a linear growth pattern and produce an increased value, say $Y X(t), where X is the increase in profit of the company since the initial investment of $Y and t represents the time of investment. Businesses retain their shareholders on the efficacy of shareholder value creation and increasingly, sustainability is becoming an inherent metric of valuing the business. However, the core management often faces the issue of striking the right balance between creating more value for the shareholders and maintaining sustainability. Hence, ESG data and certain practices can help answer these questions for investors, management, and shareholders. 

 

In recent times, the trend has shifted towards sustainable and long-term centric vision of value creation in organizations. For instance, as of 2019,  84% of the S&P500 company value consisted of intangible assets. Reputation, corporate culture, and customer loyalty are crucial components of intangible assets and investors are willing to pay more for these assets than physical assets like property, equipment and machinery. There are several underlying reasons for this and they vary from country to country.

 

The change in management methods providing stock options to company executives aligning their interests with the shareholders led to an erosion in sustainable practices and financial disclosures in early 2000s. However, the environment around options and shareholder value changed dramatically due to accounting scandals and stock market decline. 


This led to corporate collapses and an end to chasing short-term profit generation bubble that inflated the pockets of executives and shareholders. For instance, in the United States, a 2002 legislation -- Sarbanes-Oxley Act (SOX), made it mandatory for companies to institute elaborate internal controls and made corporate executives directly accountable for the accuracy of financial statements. Such legislations have driven the desire of company executives and shareholders to offset short-term value creation and substitute it with long-term value creation and incorporate sustainable practices with intangible assets for the long run. 

 

It is pertinent to note that utilising the Environmental, Social and Governance (ESG) principle to measure sustainability performance suggests that the trade-off between short-term returns and long-term value creation for companies is highly narrow. Moreover, higher sustainability companies are performing better on environmental and society-related factors and ensuring higher expected returns for their shareholders, investors, and C-suite executives. 

 

As per McKinsey Global Survey, the number of C-suite execs and investment professionals who believe ESG programs will create more shareholder value has grown to 83% in the long run. Furthermore, companies with high ratings for ESG performance are witnessing improved average operating margins by 3.7 times than companies with lower ESG performance. Consequently, shareholders also received higher annual total returns to shareholders, outpacing poorer ESG performers by 2.6 times.


 
Maintaining the balance between shareholder value creation and sustainable practices is a simultaneous process. With enhanced ESG indicators and analytics, companies can effectively measure their pitfalls and fill in the gaps for better margins. Moreover, improving value creation is not just for shareholders and C-suite executives. Using sustainable practices helps the environment and society, leading companies to contribute more towards their social responsibility. 

 

For instance, Salesforce presents a case of a company shifting to robust, sustainable practices by holding every employee and department accountable for sustainability. The company is leveraging the entire workforce to advance climate action and further operationalise sustainability across its whole business, which would help every individual contribute to the company’s value creation using sustainable measures. 

 

Bsbr Data


(Data Source: EY - Is your ESG data unlocking long-term value)

 


The graph indicates the most pertinent social risks companies are willing to target as a sustainability measure to create long-term value for shareholders and stakeholders. Therefore, companies moving towards investing more in intangible assets like customer satisfaction, reputation, labour laws and human rights across value chains will create better value instead of chasing short-term profit optimisation that harms the value in the long run. 
 

 

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