Which measures to trust?

November 24th - Edition #11

Triggered to a great extent by Milton Friedman view that the only Corporate Social Responsibility of Companies is to make profit, during the last five decades most business leaders have grown in an environment where the only return that really mattered was shareholder value creation. Several measures have been developed where the basic concern was the shareholder return. Based on any bottom-line metric (ebitda, ebit, net income, noplat, rcop, you name it) returns were calculated leading to the mother of all measures: ROCE (Return on Capital Employed, or any of its declinations).

The business community always felt very comfortable with this measure and the clear message that it sent: you did well, you did not.

In this new world where “Sustainability” becomes the strategic macrotrend, citizens and consumers are expecting a much more balanced view of managers, where all relevant stakeholders need to be taken in consideration (from suppliers to employees, from customers to local communities). It is becoming abundantly clear that the “measure of the last five decades” is not the ideal answer to measure performance. Investors need another sort of measure, but as reliable as the previous ones.

What seems to be clear is that short term financial performance alone is not enough for current investors to judge long term investments. Short term metrics are obviously key to understand companies’ performance, but they need to be “validated” by some sort of measures able to assure that future profit will be created.

Those measures are recognised as ESG (Environment, Social and Governance) metrics and are being increasingly used in investment assessments. ESG metrics give investors a more holistic view of a company’s operations, including its investments in things like reducing its environmental footprint, improving the quality of its supply chain or the satisfaction of employees and customers. These metrics also help investors to better value companies addressing the big challenges, potentially reducing the firms’ cost of capital and making it less likely to be judged purely on short term financial results.

There are hundreds of ESG measures and that does not help in terms of accountability and understanding whether any “holistic” improvement is happening. On one side, it means that indeed there is a way to measure those areas but, on the other, they are too many and none really stands out.  We are still very far from a common understanding of those that really “validate” short term and, at the same time, can guarantee the future.

In a recent report from Harvard Business School. Professor George Serafeim, a link has been drawn between public sentiment about a company’s sustainability practices and how that company is valued in the market. As the report states “the research shows companies with overall good performance in their Environmental, Social, and Governance (ESG) programs can increase their market value by carefully monitoring public sentiment about those efforts and proactively addressing issues when negative stories arise. The positive association between ESG performance and market valuation is stronger for firms with more positive public sentiment momentum. An increase in a firm’s ESG performance has nearly two to three times the effect on a firm’s market valuation for a firm with positive relative to a firm with negative public sentiment momentum.”

ESG metrics are becoming increasingly central to investment strategy and it obviously arises from the fact that more reliable data gathering, and technology, are providing evidence that ESG metrics are correlated with financial returns. But work remains to be done for the investment community to feel comfortable with the “right” ESG metrics, which will certainly vary from industry to industry.

Have a great and impactful week!

Center for Responsible Business and Leadership
Católica-Lisbon School of Business & Economics

The Center for Responsible Business & Leadership has the main purpose of contributing for Sustainability and Responsible Leadership to become part of the “way we do things in our planet”. Find out more here.

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"Have a Great and Impactful Week!" is sent out every Sunday at 5PM, bringing new insights on the world of corporate responsibility, sustainability and responsible leadership. It is often signed by the Center's Executive Director, Nuno Moreira da Cruz.