Publication on CSR facts and trends
June 2011 ı Nº 4
Sustainability for
financial geeks
CSR champions demonstrate a stronger financial performance and thus benefit from a greater potential
for value creation ultimately trading with a significant
premium when compared to their respective sectors.
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Sustainability
for financial geeks
Lessons learned from the leaders
of Dow Jones Sustainability World Index
In the quest for El Dorado of CSR, both professionals and academics have tried to link practices of corporate responsibility and business
competitiveness. Forética seeks to enrich this
debate by analysing, from a financial perspective, those companies identified as CSR leaders, in order to find some clues that confirm
or refute such claim. This paper is directed at
Finance professionals, particularly focussing
on CFOs and Investor Relations directors.
The content of this analysis is of an advanced
technical and financial character. Nonetheless, those readers who are less familiar with
the “magic” of finance may find a detailed interpretation of each aspect under analysis.
RSEARCH
This study is based on the profiles of the 19
companies identified as supersector leaders
by the Dow Jones Sustainability World Index (hereafter DJSIL). A comparative analysis
with the data from their respective sectors
has been conducted. Throughout the report,
the main strengths and weaknesses of these
companies are unravelled, eventually forming
a scorecard that encapsulates the competitiveness of the DJSIL.
Publication on CSR facts and trends
2
The 19 sample companies are the global sustainability leaders as identified by SAM (Sustainable Asset Management) in each of the supersectors within the Dow Jones classification
–as for April 2011-. Fifteen financial ratios have
been studied, reflecting the following aspects:
Margins and efficiency:
Operating margin,
net profit margin and asset turnover (measured as revenue divided by assets)
In each case we have analysed the deviations
between sustainability leaders’ performance
DJSIL and their respective sectors, in accordance with Reuters’ sectoral classification. To
eliminate statistical noise introduced by brief
time intervals, we have considered a 5 year
average for every indicator except for Beta
-which is estimated every 3 years- and asset
turnover, estimated over the last 12 months.
Growth rates:
Annualized growth rate over
the last 5 years and implicit growth rate according to market valuations.
Risk factors and cost of capital:
Operating risk (levered Beta), financial leverage (total
debt to equity), non-systematic risk (unlevered
Beta), effective tax rate and average cost of
capital.
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Methodology
Profitability:
Return on assets (ROA), return on investments (ROI) and return on equity (ROE).
Valuation Ratios:
price to earnings ratio
(P/E), price to book value ratio (P/BV) and price
to cash flow ratio (P/CF).
RSEARCH
Publication on CSR facts and trends
3
Country
Bayerische Motoren Weke AG (BMW)
Automobiles & Parts
Germany
Australia&New Zealand Banking Group Ltd.
Banks
Australia
Xstrata Plc.
Basic Resources
UK
Koninklijke DSM N.V.
Chemicals
Netherlands
Panasonic Electric Works Co. Ltd.
Construction & Materials
Japan
Itausa-Investimentos Itau
Financial Services
Brazil
Unilever
Food & Beverage
Netherlands
Roche Holding AG
Health Care
Switzerland
TNT N.V
Industrial Goods & Services
Netherlands
Swiss Re
Insurance
Switzerland
Pearson Plc.
Media
UK
Sasol
Oil & Gas
South Africa
Panasonic Corp.
Personal & Household Goods
Japan
GPT Group
Real Estate
Australia
Lotte Shopping
Retail
South Korea
Nokia Corp
Technology
Finland
Telefónica S.A.
Telecommunications
Spain
Air France KLM.
Travel & Leisure
France
Gas Natural SDG S.A.
Utilities
Spain
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Supersector
Name
Sources of Information
The sources of information used for this work
were the following: Reuters, Bloomberg, UBS
RSEARCH
WMR, FactSet, Dow Jones Sustainability
Indexes and Forética.
Publication on CSR facts and trends
4
Along the profit and loss account, companies build up expenses reflecting production,
staff and financial costs, among other general
expenses. Two indicators are specifically significant when it comes to assessing the performance of a particular business. That is the
operating and net margins.
Firstly, the operating margin indicates how
much of a company’s revenue is left after paying those costs directly related to its main activity. Secondly, the net margin, which considers financial costs, one-time items, and taxes,
in addition to pure operating expenditures.
Operating Margin
In terms of operating margin, DJSIL companies are seen to perform better than their respective industries. 74% of these firms reach
higher operating margins than their sector,
generating on average an additional 146%
positive deviation. Digging deeper we realize
-as will occur numerous times in this analysisthat differences between the DJSIL and their
sectors present a strong dispersion, i.e. are
widely spread.
DJSIL operating margin
Figure 1
-5
In such cases, the median proves to be
the most adequate statistical measure as
it is less affected that the mean by the
strong biases that volatility introduces1.
For the purpose of this analysis it provides a
more reliable interpretation. Median deviation in DJSIL’s operating margin is of +14.86%
with regards to their sectors.
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Margins and efficiency
Operating
Margin
versus
Sector
Operating
Margin --DJSIL
DJSIL versus
Sector
45
40
35
30
25
20
15
10
5
0
y = 1,0979x + 2,5073
R² = 0,6301
0
5
10
15
20
25
30
Sector operating margin
1 The median is the value in the middle of a data set arranged in ascending order, which means half of the values in the data
set lie below the median and the other half lie above it. In contrast, the mean of a data set is the average obtained when
distributing evenly the sum of all of the data values. Both often differ, especially if the data set includes extreme values. Take
the following situation as an example. During lunch, ten friends have lunch at a restaurant.. Eight of them choose the 10€
menu and the remaining two spend 70€ each. In this case, average spending per person is of 22€. However, median spending
is of 10€. 80% of people have spent 10€ and still the mean is 2.2 times the median. Therefore, the median is a more reliable
indicator if the aim is to measure how much money a person normally spends on lunch, even if some guests may have spent
7 times more than others.
RSEARCH
Publication on CSR facts and trends
5
As one moves along the profit and loss account and start taking into account those expenses not directly related to the core business, sustainability leaders give up a large
portion of the premium obtained at the stage
of operating margins.
The reason is, essentially, the greater use of
financial leverage when financing activity
(Refer to “Applying DuPont to sustainable
businesses”). A larger debt, all things being
equal, results in higher interest payments and
ultimately reduces the net margin.
Deviation of Net Margin
Deviation
of Net Margin
Figure 2
TNT
GPT Group
ANZ Bank
Roche
Sasol
Telefónica
Unilever
Lotte Shopping
Nokia
Itausa
Xstrata PLC
Air France
BMW
Pearson
Panasonic Corp.
Panasonic Electric Works
Gas Natural
DSM NV
Swiss Re
-20
-10
0
10
68% of DJSIL have a higher net margin than
their respective sectors. It then appears that
they lose the gloss of an advantage over their
sectors. Median estimation indicates a premium of 43.36% for DJSIL whereas the mean, still
RSEARCH
20
30
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Net Margin
40
highly affected by volatility, suggests an average deviation of 92%. Thus, cost of debt draws
closer the sustainability leaders and their sectors, although these hold its profit generation
premium.
Publication on CSR facts and trends
6
93.8% of DJSIL companies have higher asset
turnover than their respective sector. Asset
turnover of DJSIL companies is 0.71 times that
of sales, versus 0.20 as the sectoral average.
This indicates that the pool of companies is
over three times more efficient than the average sector2.
In this section we not only measure how
much it is gained for each euro of sales, but
also how efficiently is generated. One of the
most common indicators in financial analysis
is the asset turnover ratio, measuring how
many times a company’s sales exceed its assets. It seems reasonable to assume that it is
far more efficient to reach sales add up to ten
million Euros holding one million Euros worth
of assets rather than twenty. The higher the
turnover, the more flexible companies are,
hence they will need to invest less money,
thus reducing their financing needs while
minimizing their cost structure.
Asset Turnover
DJSIL
n.a.
n.a.
Panasonic
Electric Works
n.a.
Itausa
Xstrata PLC
Unilever
TNT
Telefónica
Swiss Re
Sasol
Roche
Pearson
Panasonic Corp.
Nokia
Lotte Shopping
GPT Group
Gas Natural
DSM NV
BMW
Air France
1,6
1,4
1,2
1
0,8
0,6
0,4
0,2
0
ANZ Bank
Asset Turnover
Figure 3
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Asset turnover
Sector
2 ANZ Bank, Itausa and Panasonic Electric Works have not been included in the calculation for this indicator. The information
was not reached by the research team.
RSEARCH
Publication on CSR facts and trends
7
less misleading and points at -40%. This does
not imply that the sales of pool of companies
are declining. In fact, they have grown at an
annual rate of 7.75%. In contrast, it does mean
that they have only grown a fraction of that
which the overall sector has grown (10.35%).
Growing below average over long periods of
time results in a loss of leadership and market
share which in a competitive milieu indicates
financial unsustainability.
Sales and profit growth rates are one of the
most important elements when valuing a
business. If the sample of DJSIL is weak in
one aspect, it is precisely in terms of its sales
growth over the past five years in comparison with their respective sectors. Only 39%
of companies have surpassed their sectors
in terms of sales growth rate. Results undoubtedly prove a deviation from the sector.
Despite the mean indicating that DJSIL have
outgrown their sectors by 11%, the median is
Deviation
of annual
growth rate
over the
last 5
Difference
in annual
growth
rate
over the years
last 5 years
Figure 4
Itausa
Telefónica
Xstrata PLC
Gas Natural
Lotte Shopping
Sasol
TNT
Roche
Nokia
Air France
Pearson
BMW
Swiss Re
ANZ Bank
Unilever
Panasonic Corp.
DSM NV
GPT Group
Panasonic Electric Works
-50
-40
-30
-20
Nevertheless, growth rates collect historical
and not future data. We will see further on
that markets expectations foresee -on 61% of
RSEARCH
-10
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Sales Growth
n.a.
0
10
20
30
cases- that DJSIL will outgrow their sectors in
the future (Refer to “Added-Value and CashFlows”).
Publication on CSR facts and trends
8
Any business’s risk and cost of capital are
closely linked. A professional investor -presumably a rational individual- will always expect greater profitability from a riskier company or activity than a safer one. In other words,
higher expected returns should compensate
investors for the higher probability of failure.
Therefore, risk is a basic element for pricing
financing costs of a project or a business.
RSEARCH
There exist two types of risks which are critical from a financial point of view: business and
financial risk. We will analyse below the basic
components of businesses’ financing costs.
Publication on CSR facts and trends
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Risk and Cost of Capital
9
tively. On the other hand, the financial stability of income, margins and cash flow. If a
company’s income and net margin are subject
to a great variability, access to debt is not an
option, as it is the case in start-ups. In contrast, solid companies may turn to debt when
margins are high and income is stable, regular
and predictable, without this affecting business’ fundamentals.
A company’s financial debt is a double-edged
sword. On the one hand, it enables the financing of business activity, relieving the burden
of the shareholders and boosting company’s
profitability. However, when excessive sums
are borrowed or the business performance
deteriorates, debt can strangle the business,
wasting away profits and draining cash reserves. Debt sustainability depends on two
fundamental factors. On the one hand, to
what extent its cost can compromise profits
and cash positions as the company faces interests and pays back the principal, respec-
Figure 5
Deviation
ofoftotal
debt
equity
Deviation
total debt
toto
equity
Roche
BMW
Telefónica
Gas Natural
Swiss Re
TNT
Pearson
Unilever
DSM NV
Panasonic Corp.
Nokia
ANZ Bank
Xstrata PLC
Sasol
Air France
Lotte Shopping
Panasonic Electric Works
Itausa
GPT Group
-150
-100
-50
0
50
DJSIL companies are far more indebted than
their respective sectors in 63% of the cases.
Mean and median deviations are +23% and
+186% respectively. This entails a greater fi-
RSEARCH
100
150
200
250
300
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Total debt to equity
350
nancial risk but at the same time reveals a
higher confidence in the stability and continuity of their business affairs.
Publication on CSR facts and trends
10
The bad news is that when the market crashes, this company will almost double the losses. Therefore, risk and profitability are always
directly proportional.
The beta coefficient is one of the most critical
parameters when determining a company’s
cost of capital. It constitutes an indicator of
the specific risk that a particular company entails when compared to the rest of the market. Therefore, an investor can easily estimate
how much a company’s shares are expected
to rise or fall in relation to the trend set up
by a stock market index. When a business is
equally risky than its market, its beta is equal
to 1, as the share responds to the movement
of the stock market to the multiple of one. A
business with a greater risk than the market
will have a beta bigger than 1, amplifying the
movement of the market to the multiple of
beta. The highest beta in the sample is associated to Xstatra PLC, with a coefficient of 1.83.
This means that if the market rises by 10%,
one could expect the share to rise by 18.34%.
For this reason, it is very important to prepare
the information in order understand beta correctly. This coefficient signals the total risk
borne by a particular stock. Therefore, for the
purposes of the analysis it is convenient to
isolate and observe separately two different
risk factors: the specific business risk associated with a firm’s operations on the one hand,
and the risk that is derived solely from the
firm’s capital structure, on the other. Financing decisions that determine capital structure
are a matter of choice and opportunity for
each company.
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Levered beta versus unlevered beta
Risk factors:
and
unlevered
Risk factors:Levered
Levered and
unlevered
beta beta
Unlevered ɓ
Levered ɓ
Sector Levered ɓ
Sector Unlevered ɓ
Gas natural
Air France
Telefonica
Nokia
Lotte Shopping
GPT Group
Panasonic Electric…
Sasol
Pearson
Swiss Re
TNT
Roche
Unilever
Itausa
Panasonic Corp.
DSM NV
Xstrata PLC
ANZ Bank
Figure 6
BMW
2
1,8
1,6
1,4
1,2
1
0,8
0,6
0,4
0,2
0
3 Debt affects cash flow per share, since it reduces net profit and introduces a fixed charge for interest and principal repayment. Cash ultimately available to pay dividends is therefore more volatile with respect to sales’ variability. .
RSEARCH
Publication on CSR facts and trends
11
DJSIL companies show a slightly lower risk
than the market in terms of unlevered beta
( u). 58% of them have a lower u than their
sectors and the median indicates a deviation
of -3.4%. With that in mind, we can say that
DJSIL’s business risk is more moderate than
their competitors’.
This puts a great deal of pressure -at least
from a technical and financial standpoint- on
one of the mantras of corporate responsibility advocates stating that sustainable companies entail lower risks than their competitors,
since their more responsible practices minimize operational risks. Our findings show that,
while DJSIL companies show a slightly lower
risk than their respective sectors in terms of
u, their greater appetite for debt makes them
a higher risk investment alternative than their
sectors. This need not necessarily be negative
since, as we will see later on, debt can have
a positive effect on business’ cost of capital.
However, as we have previously noticed, the
consideration of DJSIL’s larger debt artificially
magnifies their investment risk profile. Only
47% of DJSIL’s levered beta are lower than
their respective sectors’ and the median deviation is +17%.
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Therefore, a discretional fact introduces an
additional amount of risk3 that makes it impossible to compare two companies’ corresponding betas if one is indebted and the
other is not. Hence, we must distinguish between two different betas: the levered beta ( ,
which considers debt) and the unlevered beta
( u, which factors out the debt risk). Two factors are necessary in order to estimate both:
total debt and effective tax rate4.
4 Seen as debt interests are tax deductible, they generate a tax shelter, which de facto reduces the actual cost of debt. Thus,
the actual debt cost of a company paying 7% interest and whose tax rate is 35% will be 4.55%% (7% x (1-35%)).
RSEARCH
Publication on CSR facts and trends
12
have a lower tax burden paying on average a
tax 23% below that of their competitors. This
has both pros and cons. On the one hand, a
lower tax burden increases cash flow per share
and in consequence generates higher returns
for any investor. However, the lower the taxes,
the higher the real cost of debt, as interests are
tax deductible. This gives place to a higher cost
of capital. Nonetheless, benefits exceed costs,
which ultimately leads to a higher value of CSR
champions.
Effective tax rate is yet another factor determining the financing costs of a firm. The
higher the tax rate, the more attractive the option becomes of turning to debt to finance the
company. This is due to the fact that financial
interests are tax deductible and so reduce the
actual cost of debt.
Taxes play an important part when evaluating
DJSIL companies, since their tax rate is lower
than their sectors. 63% of such organizations
Cost of Capital
We have estimated each DJSIL and each sector’s cost of capital. Results are truly favourable to the DJSIL. 58% of sustainability leading companies show a lower cost of capital
than their sectors. Median deviation –more
adequate in this case due to the presence of
extreme values– is -7.9% whereas mean deviation is -4%. Further on we will analyze more
in depth the links between cost of capital and
a company’s market capitalization.
Companies and sector’s cost of capital
(WACC) can be estimated if the right components are at our disposal5. We have just seen
many of them, and also the most important
ones. The cost of capital determines a company’s market value: the lower the cost of
capital, the more the company is worth and
vice versa.
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Effective tax rate
Cost of Capital - LDJSI vs. Sector
Cost of Capital – DJSIL vs. Sector
Figure 7
0,25
0,2
0,15
0,1
0,05
Deviation
Company's WACC
Air France
GPT Group
Xstrata PLC
Lotte Shopping
Panasonic Electric Works
Swiss Re
Sasol
Itausa
ANZ Bank
Unilever
TNT
Nokia
Panasonic
Gas natural
Pearson
DSM NV
Telefonica
-0,1
BMW
-0,05
Roche
0
Sector's WACC
5 Components of Cost of Capital, according to the CAPM model: 1. Cost of Equity Capital: proportion of equity versus total
capital, risk free rate, expected market return, risk premium and beta (levered). 2. Cost of Debt Capital: proportion of debt
versus total capital, nominal cost of debt, corporate tax rate.
RSEARCH
Publication on CSR facts and trends
13
In this section, profitability ratios will be analysed. Two indicators of profitability will be
evaluated to that end: return on assets and
return on equity.
Return on Assets (ROA)
This ratio links a company’s earnings and its
total assets. Thus, ROA is a sub-product of net
margin and it should then be related to the
previous section on Margins and Efficiency.
Deviation of
Deviation
ofROA
ROA
Figure 8
TNT
Roche
Nokia
Sasol
Lotte Shopping
Telefónica
Unilever
Itausa
Air France
ANZ Bank
BMW
Swiss Re
GPT Group
Panasonic Corp.
Pearson
Gas Natural
DSM NV
Xstrata PLC
Panasonic Electric Works
-8
-6
-4
-2
DJSIL’s ROA are higher than their sectors’.
Two statistical phenomena can be observed
in this case: volatility, which as we have previously seen can introduce biases when interpreting the mean; and distribution symmetry,
which in turn reflects a large range of data.
As the chart below shows, both profiles tails
(above and below cero) look very similar. Analysing the data vis á vis we observe that 58%
RSEARCH
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Profitability
n.a.
0
2
4
6
8
of selected companies benefit from a higher
return on assets than their sectors. Mean
and median deviations are of +39.4% and
+23.95% respectively. Differences are nevertheless neutralized when aggregated data is
analysed, signalling similar levels of return on
assets among DJSIL and their corresponding
sectors. The former show a ratio of 5.49% and
the latter, 5.20%.
Publication on CSR facts and trends
14
Return on equity links a company earnings
and shareholders’ equity. Given equal earn-
ings, the less equity a business owns, the
greater return the shareholder will obtain.
Deviation
ofROE
ROE
Deviation of
Figure 9
Telefónica
Itausa
TNT
Nokia
Unilever
Roche
Sasol
Air France
Lotte Shopping
ANZ Bank
BMW
Panasonic Electric Works
Gas Natural
Swiss Re
Pearson
GPT Group
Xstrata PLC
Panasonic Corp.
DSM NV
-20
-10
0
Despite of the fact that in only 57.9% of the
cases DJSIL appear to have a higher return
on equity that their respective sectors, median deviation indicates a higher return for
selected companies. The median difference is
+5.20% and the mean is +48%. Considering
that DJSIL’s ROA are consistent with their sectors’, this means that DJSIL are able to draw a
10
20
30
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Return on Equity (ROE)
40
more efficient financing structure thanks to
the stronger fundamentals of their businesses (above average operating margins, greater
efficiency and lower cost of capital). A higher
leverage increases profitability through a decrease in the use of equity for financing investments.
6 Financial leverage refers to the use of debt, instead of equity, to finance a company’s projects. Debt reduces the need of
financing via shareholders’ contributions thus introducing a multiplier effect on profitability.
RSEARCH
Publication on CSR facts and trends
15
So far a number of financial indicators have
been analysed establishing positive and negative differences that affect companies selected
within the DJSIL. Next, we will move onto the
definitive examination. How do the markets
interpret these variables? Do they really assign value to such statistics? So as to answer
these questions we will analyse various ratios
linking share price to factors such as earnings,
assets’ book value, and cash flow per share.
RSEARCH
By linking share price with the aforementioned parameters, we can appreciate how
many times the market pays each variable
setting grounds for a uniform comparison. It
appears logical to assume that any investor
would pay more for a better managed company than for another with poor credentials.
One would also pay a premium for a business
which can generate further growth in the future than for a stagnant business.
Publication on CSR facts and trends
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Valuation ratios
16
This indicator, one of the most commonly
used among professional and amateur investors, links share price with net profit per
share. A more frequent use -with regards to
other valuation ratios and techniques- is due
to its simplicity and easy analysis, especially
when data from an overall sector or geographical market is aggregated. If an investor pays
a higher price for a certain company´s earnings over a competitor’s it can be attributed to
the market seeing an additional value in the
former.
Deviationof
of
P/E
Deviation
P/E
Figure 10
Air France
Sasol
Xstrata PLC
BMW
DSM NV
TNT
Lotte Shopping
Panasonic Corp.
Swiss Re
Pearson
Nokia
Telefónica
ANZ Bank
Itausa
Roche
Gas Natural
Unilever
GPT Group
Panasonic Electric Works
-60
RSEARCH
-40
-20
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
P/E Price-to-earnings ratio
n.a.
0
Publication on CSR facts and trends
20
40
17
This variable presents a considerably wide dispersion. For example, Air France’s P/E is 1853%
higher than its sector, while estate agent GPT’s
is 92% lower than its corresponding sector.
Nevertheless, in 61% of cases sustainable
companies’ P/E is higher than their respective sectors. Median deviation with respect
to their respective sectors is +28%, while the
mean is +228%. This indicates that -a general
observation- one Euro of earnings generated
by a sustainable company is worth more than
a Euro of its competitors.
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Such premium may derive from a sounder
management, a stronger competitive position,
lower specific risks or larger long-term growth
opportunities. In a competitive market – and
the stock market certainly is so – the ratio between prices and earnings of two companies
with the same risk and growth profile should
approach until they share the same valuation
in terms of P/E7.
7 The stock market is a competitive market. Investors continually monitor share prices. As an example, let´s think about the
price of any good in a local market. Imagine there are two villages a few kilometres away from each other. Both villages have
their own gas station and tax rates for gasoline are equal in both cases. At any given time, gas in city A is sold at 1€ a litter. City
B sells at for 0.5€ a litter. Assuming that it is a competitive market with no restrictions to travel and trade, both villages should
end up with an identical equilibrium price. Demand from the expensive village would move to the cheaper one, incentivizing
the former gas manager to lower prices to retain its customers. At the same time, the cheaper village gas manager would see
demand grow giving her room to increase prices to improve its local earnings. Ultimately both villages would end up with
the same price for gasoline. This is the same phenomenon that occurs to P/E ratios. All things equal two identical companies
should have equal P/E, or investors could make a quick -immediate- profit. As we already noted this should not possible in an
efficient and competitive market.
RSEARCH
Publication on CSR facts and trends
18
One of the most repeated assertions in the
business management world over recent years
is the greater influence of intangible assets on
a company’s value. Such increasing influence
may be appreciated by contrasting shares’
price and their book value. Indeed, prices
increasingly reflect real assets in a smaller proportion, while intangible or growth assets get
the lion´s share of enterprise value.. Brands,
innovative capacity, and quality of management team are among the most commonly
valued intangible assets.
Deviation
Deviationof
ofP/BV
P/BV
Figure 11
Roche
Unilever
Telefónica
TNT
BMW
Xstrata PLC
ANZ Bank
Pearson
Gas Natural
Nokia
Lotte Shopping
Panasonic Electric Works
Swiss Re
Panasonic Corp.
Sasol
Itausa
GPT Group
Air France
DSM NV
-2
0
2
Sustainable companies’ intangible assets are
worth more than their respective sectors’. Such
is the case in 58% of the observations. DJSIL’s
share price is 2.35 times its book value versus a
4
6
8
10
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
P/BV Price-to-book value ratio
12
ratio of 1.31 shown by the overall sectors. Median deviation is 28.6% and mean is 105%8.
8 Please note that mean deviation is not obtained by calculating the variation in percentage terms of total means. Some
experienced readers may have perceived an apparent miscalculation. Given that DJSIL’s mean is 2.35 and that of the respective sectors is 1.31, mean deviation would be 79%, and not 105% as previously stated. Under this analysis mean deviations
result from finding the average of the percentage deviations of each company from its respective sector. Strong fluctuations
between one company and the next have an increasing effect on mean deviation. In contrast, if one calculates the mean of
the entire sample, considering each of the 19 cases, fluctuations are softened, as is the case of moving averages. Hence, it is
considerably different to follow one or another method.
RSEARCH
Publication on CSR facts and trends
19
“Cash is King”. This is the motto of financial
professionals. Accounting earnings are the
by-product of applying a number of accounting principles plus an extensive quantity of legal, financial and sectoral requirements. It is
therefore subject to distortions and, to make
it even more challenging, accounting principles may t differ from one country to another.
This turns the focus to cash as it is factual and
ultimately it is the only material source to pay
cash dividends, regardless of the accounting
criteria applied. Price-to-cash flow ratio indicates how much an investor pays for every
euro of cash flow. This is one of the variables
in which the DJSIL’s ability to create added
value is most obvious.
Deviation
P/CF
Deviation
of of
P/CF
Figure 12
Sasol
DSM NV
Lotte Shopping
ANZ Bank
Swiss Re
Panasonic Corp.
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
P/CF – Price-to-Cash Flow ratio
TNT
BMW
Telefónica
Pearson
Roche
Panasonic Electric Works
Nokia
Xstrata PLC
Air France
Itausa
Unilever
Gas Natural
GPT Group
-22
-17
-12
-7
61% of the DJSIL present a higher ratio of
price-to-cash flow than their sectors. Median
deviation is +24%, while mean is +185%. This
RSEARCH
-2
3
8
could be even higher if it were not because of
GPT’s strong discount against its sector that
creates a strong bias.
Publication on CSR facts and trends
20
As it has been demonstrated throughout this
report, there exist strong links between sustainability champions and a stronger financial
performance. All through the scorecard below, one can appreciate a more competitive
positioning. Those aspects in which the DJSIL
beat their respective sectors are highlighted
in green. Orange indicates a consistency between the pool of companies and sectors,
and finally distinctly unfavourable values are
shown in red.
Dimension
Margins and Efficiency
Growth Rates
Risk factors and Cost of Capital
Profitability
Valuation Ratios
As previously explained, the fact that observations are widely spread makes the interpretation of the mean to be strongly biased
as it softens extreme values. Consequently,
we base our analysis in median and mean
deviations. When studying for example sales
growth, median and mean result in conflicting
interpretations. Therefore, as a precaution, we
recommend the use of the median as a sounder statistical measure9.
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Conclusions: DJSIL and added value
creation
% of companies
outperforming
their sectors
Median
Deviation
Mean
Deviation
Operating Margin
73.7%
14.9%
146.1%
Net Profit Margin
68.4%
43.4%
91.6%
Asset Turnover
93.8%
276.9%
816.3%
Sales growth
38.9%
-40.5%
11.3%
Implicit growth
61.1%
3.7%
15.2%
Unlevered Beta
57.9%
-3.4%
-0.7%
Levered Beta
47.4%
17.0%
24.5%
Debt to Equity
63.2%
23.0%
185.6%
Effective Tax Rate
63.2%
-7.1%
-22.8%
Cost of Capital
57.9%
-7.9%
3.8%
ROA
57.9%
23.9%
39.4%
ROI
53.3%
2.1%
30.8%
ROE
57.9%
27.4%
59.8%
P/E
61.1%
28.0%
228.0%
P/BV
57.9%
28.6%
105.5%
P/CF
61.1%
24.0%
185.4%
Indicator
9 In this case the sample is constituted by 19 observations presenting extreme values that make it impossible to assume a
normal distribution. Thus, it is authors’ belief that in this exceptional scenario the median can be a sounder measure of the
actual position of DJSIL.
RSEARCH
Publication on CSR facts and trends
21
Margins and Efficiency: Passed. Based on a
premium obtained at the stage of operating
income, DJSIL companies are able to generate
superior margins thus passing this test. They
also benefit from more efficient asset structures generating higher income with fewer resources.
Growth Rates: Failed. Under the viewpoint
of sales growth, sustainable companies fail the
test. Competitors have outgrown DJSILs over
the last five years. Growing below average entails a high risk as in the near future it may result in a loss of leadership and market share.
Nevertheless, the section “Added-Value and
Cash-Flows” will prove that current market
valuations discount a higher implicit growth
for DJSIL´s against their peers.
Risk factors and Cost of capital: Passed.
DJSIL companies are capable of reducing their
financing costs -starting from a slightly lower
business risk than their industries- through
a more efficient funding mix. Consequently,
these organizations benefit from a greater potential for shareholder added value.
RSEARCH
Profitability: Passed. Sustainable companies
are in a position to generate higher returns
than their competitors. In addition, they create more profitability for shareholders as they
beat the sector in terms of return on equity.
Thus anchored on stronger operating margins,
LDJSI can lever into a more efficient and profitable financial structure.
Valuation Ratios: Passed. The analysis conducted so far is corroborated by the market.
Shares from the mix of selected companies
trade with a significant premium when compared to their respective sectors, revealing a
greater confidence in these companies’ management.
• P/E: in 61% of cases, companies’ stock market worth per euro of profit is higher than their
competitors’ with a median deviation of +28%.
• P/BV: 58% of companies benefit from a higher ratio of share price versus book value, when
compared to their respective sectors with a
median deviation of +28.6%.
• P/CF: 61% of companies’ shares obtain a
premium in their price with a median deviation of +24%.
Publication on CSR facts and trends
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Having tested each indicator, we are now in a
position to pass a final verdict on each aspect
under evaluation.
22
serve as an ultimate test to our list of sustainable champions.
As it has been stated along this report, DJSIL
businesses benefit from a greater potential for
the value creation, in comparison to their respective sectors. We are now going to examine how this selection of companies performs
under widely accepted finance theory. This
section intents to help some readers understand some of financial technicalities and to
We will firstly observe what occurs when the
discounted cash flow method is applied to
value companies. Later on we will analyse the
impact of applying the DuPont identity to the
pool of sustainable companies.
Added Value creation and Cash Flows
This hurdle rate is in fact the expected return
that the market demands of any investment
of equal risk as the project under evaluation.
Valuation methods state that the price of any
financial asset, such as shares, bonds or derivatives, is equal to discounting to the present
the value of its present and future expected
cash flows. That is to say, evaluate today the
real value of a stream of future payments that
we expect the asset will deliver during its
lifetime. In order to discount to the present
value, a so-called hurdle rate will be needed.
The enterprise value of a company can be expressed in terms of the present value of future cash flows it generates when growing at
a constant rate (g)10.
Enterprise Value =
CF
r-g
present value of growth opportunities. In the
first term, we can therefore appreciate how
much a euro of cash flow is worth assuming
the company is at a standstill (g=0). On the
other end we can identify how much value
is being priced in for the expected future
growth. Enterprise value is thus equal to the
sum of these two values
Brealey, Myers and Allen, in their work Principles of Corporate Finance, explain the process
of valuation of a company with a very simple
method that illustrates the most important
components of the valuation. Enterprise value
can be split into two elements. The first term
is the cash flow that the company is capable
of generating today. The second term is the
CF
Enterprise Value =
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Reconciliation with financial theory
r-g
Business
continuity
+
+
PVGO
Growth
opportunities
10 Constant rates do not exist in the real world, but one can always estimate an average annual growth rate so as to simplify
calculations without affecting valuations substantially.
RSEARCH
Publication on CSR facts and trends
23
Company's
WACC
Sector's
WACC
Company's
value
Sector's
value
Premium
g=0
BMW
7.4%
13.5%
13.5 €
7.4 €
82.2%
ANZ Bank
8.3%
8.8%
12.1 €
11.3 €
6.6%
Xstrata PLC
19.3%
16.6%
5.2 €
6.0 €
-14.2%
DSM NV
12.9%
17.4%
7.7 €
5.8 €
34.3%
Panasonic Corp.
11.5%
13.6%
8.72 €
7.4 €
18.3%
Itausa
9.1%
8.8%
11.0 €
11.3 €
-3.2%
Unilever
11.2%
12.2%
8.9 €
8.2 €
8.6%
Roche
6.9%
13.4%
14.5 €
7.5 €
95.1%
TNT
11.6%
12.6%
8.6 €
7.9 €
8.8%
Swiss Re
13.8%
13.2%
7.2 €
7.6 €
-4.3%
Pearson
14.8%
12.6%
6.7 €
7.9 €
-14.9%
Sasol
15.8%
15.4%
6.3 €
6.5 €
-3.0%
Panasonic Electric Works
13.3%
17.6%
7.5 €
5.7 €
32.9%
GPT Group
17.2%
8.0%
5.8 €
12.4 €
-53.2%
Lotte Shopping
14.4%
11.7%
6.9 €
8.5 €
-18.7%
Nokia
13.1%
14.9%
7.7 €
6.7 €
14.2%
Telefónica
7.4%
10.1%
13.5 €
9.9 €
35.9%
Air France
17.1%
7.5%
5.9 €
13.3 €
-55.9%
Gas Natural
8.8%
10.9%
11.3 €
9.1 €
24.0%
The table above consists of the following elements. The first two columns reflect the cost
of capital of each company and its respective
sector. The following two columns reflect the
monetary value of each euro of cash generated per share. Please note that when estimating the value per euro of cash flow we are implicitly estimating price-to-cash flow ratio. So,
in the case of BMW, each euro of cash flow
generated today and in the future –assuming null growth- would be worth 13.5€. Within
the overall automobile sector however, this
same euro of cash would only be worth 7.4€.
RSEARCH
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Sustainable companies’ cost of capital -as well
as their respective industries’- has been already
estimated. So, we will apply the formula for the
first component of enterprise value, that is, the
value of each euro of cash generated assuming
zero growth.
Consequently, the identity consists of the value associated to business continuity and the
present value of growth opportunities.
The difference between those two values,
13.5€ and 7.4€, in terms of percentage, is the
82% premium that the market is willing to
pay for BMW for its ongoing business. The
last column then reflects valuation premium,
that is, the premium or discount for the company’s value compared to its sector, assuming zero growth for both. As it has just been
explained, BMW benefits from a premium
of 82%. In contrast, any investor would pay
53.2% less for GPT Group than the overall real
estate sector.
Publication on CSR facts and trends
24
having a higher or lower cost of capital as a
competitive advantage when compared with
each sector.
Valuation premium given g=0
Valuation premium given g=0
Figure 14
0,95
Roche
BMW
0,8
Telefónica
DSM NV
0,65
Pearson
Gas Natural
0,5
Panasonic Corp.
0,35
TNT
0,2
Unilever
ANZ Bank
0,05
Sasol
Itausa
-0,1
Swiss Re
Xstrata PLC
Valuation Premium
Nokia
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
This proves that the cost of capital is a critical
variable determining the premium in a company’s value. Hence the great importance of
-0,25
Panasonic Electric Works
Lotte Shopping
-0,4
GPT Group
Air France
-0,55
0
2
4
6
8
10
12
14
16
Price-to-cash flow Ratio (number of times)
Premium g=0 (right)
RSEARCH
Sector P/CF (hor.)
Company P/CF (hor.)
Publication on CSR facts and trends
25
obtains market’s valuation premium of company’s cash flow. Considering that we are
now basing our estimations on real data, real
market price-to-cash flow reflects both business continuity and present value of growth
opportunities.
Real Market P/CF
RSEARCH
DJSIL
Company
Sector
Valuation Premium
BMW
6.15
3.07
100%
ANZ Bank
12.13
4.98
144%
Xstrata PLC
13.74
14.86
-8%
DSM NV
10.85
1.24
775%
Panasonic Corp.
8.16
2.27
259%
Itausa
2.44
4.98
-51%
Unilever
11.97
15.46
-23%
Roche
8.48
8.34
2%
TNT
10.43
6.61
58%
Swiss Re
9.19
2.33
294%
Pearson
12.51
11.52
9%
Sasol
11.00
0.65
1592%
Panasonic Electric
Works
n.a.
n.a.
n.a.
GPT Group
3.95
25.66
-85%
Lotte Shopping
9.66
2.15
349%
Nokia
9.92
10.96
-9%
Telefónica
4.14
2.97
39%
Air France
1.86
3.12
-40%
Gas Natural
3.87
12.82
-70%
Publication on CSR facts and trends
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Next, we will evaluate the second element
of enterprise value: present value of growth
opportunities. In order to do so, we must obtain market data. We have analysed before
company´s valuations by using the ratio of
cash flow per share. By linking a company’s
price-to-cash flow ratio with its sector’s one
26
Based on the information analysed so far, we
are now in the position of estimating the implicit growth rate assumed by the market (g)
in Nokia's case. We only need to find its value
in a simple identity: price per euro of cash
flow in a no-growth scenario is known (7.73)
and so is the present value of growth opportunities (9.92 – 7.73 = 2.19). Thus, it’s only a
matter of finding the value of g.
Consequently, the market assumes Nokia’s
cash flow will grow at a rate of 2.98%, versus
5.80% expected for the overall sector.
( CF - P * WACC )
g= -
g= -
( 1 - 9.92 * 13.1%)
= 2.98%
9.92
P
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
According to the methodology outlined by
Brealey, Myers and Allen, the difference between price-to-cash flow ratio assuming zero
growth and the market P/CF can only be attributed to the implicit growth rate assumed
by the market. As pointed out by the first table in this section, Nokia’s price per euro of
cash flow assuming zero growth indicates its
valuation should be of 7.7€, that is, a priceto-cash flow ratio of 7.7 times. However, the
company’s actual P/CF is of 9.92. Hence, the
difference between the former and the latter
is merely due to market’s assumption that
Nokia will continue to be outgrown by the
overall technology sector over the course of
following years.
Connection between valuation
and cash flow growth
Connection between valuation and cash flow growth
160,00%
16
140,00%
14
120,00%
12
100,00%
10
80,00%
8
60,00%
6
40,00%
4
20,00%
2
0,00%
0
-20,00%
Sasol
DSM NV
Lotte Shopping
Swiss Re
Panasonic Corp.
RSEARCH
ANZ Bank
As the figure above shows and -contrary to
earnings’ evolution during the past 5 yearsmarkets assume a higher growth in the case
BMW
Market premium
Telefónica
TNT
Pearson
Xstrata PLC
Nokia
Premium g=0
Unilever
Roche
Air France
GPT Group
Gas Natural
Itausa
-2
Implicit growth rate
Valuation premium
Figure 15
18
-40,00%
Growth deviation in the long term (right)
of sustainable companies when compared to
growth expected for their respective sectors.
Publication on CSR facts and trends
27
Converging companies
Converging companies
Market
versus
no-growth premium
Market versus no-growth premium
Figure 16
1,5
1
0,5
Premium g=0
BMW
Telefónica
TNT
Pearson
Xstrata PLC
Nokia
Unilever
Roche
Air France
GPT Group
-1
Gas Natural
-0,5
Itausa
0
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
ket premium clearly diverges from the corresponding no-growth premium. Firms in
this group are characterized by a low level of
maturity and great exposure to emerging or
cyclical markets.
As a result of contrasting the no-growth
versus the actual premiums priced in by the
market, we can observe a consistent selective correlation. On the one hand, we identify a group of converging companies whose
market premium is not significantly distinct
from no-growth premium. On the other hand
and in the case of diverging companies, mar-
Market premium
Diverging companies
Diverging companies
Market versus no-growth premium
Figure 17
Market versus no-growth premium
20
15
10
5
0
-5
ANZ Bank
Panasonic
Corp.
Swiss Re
Premium g=0
RSEARCH
Lotte
Shopping
DSM NV
Sasol
Market premium
Publication on CSR facts and trends
28
The DuPont analysis represents one of magic
formulas available to easily assess the financial
performance of a company. It is named after
the DuPont Company, which started to apply
this method in the 1920s. The model breaks
down the theoretical return for an equity investor into three components: profit (sales
and operating margin), investments necessary
for business operations (effectiveness of assets in place), and funds committed by shareholders to finance activity (equity paid-in).
The first component in the DuPont formula is
profit margin, which links sales and net profit.
This ratio reveals two underlying elements.
Firstly, a company’s operating efficiency in
generating operating income, and secondly
its capacity to generate profit having paid
interests and taxes (net margin). Do note
that, while taxes are non-negotiable, turning to debt is up to each company’s funding
preferences.
The following analysis is based on companies’
and industries’ median values. As noted along
this report, we remind our readers that the
strong dispersion observed in the sample justifies the use of the median over the mean. Results obtained may differ from the mean but
they will certainly be more robust.
RSEARCH
The starting point for 74% of selected companies is of a higher operating margin than
their sectors’. However, as seen above, DJSIL’s
greater appetite for debt as a source of funding ultimately makes these companies converge to their sectors at the net margins level,
that is after paying interests and taxes. The
question that comes in next would be if it is
smart to start from a substantially higher margin and then assuming debt to end up with
profitability similar to one’s peers? Let’s take a
look at what happens with other components.
DJSIL companies reach an operating margin of
13.27% versus 11.59% on the side of respective
sectors. After detracting interest and taxes,
the net margin is of 8.55% compared to 6.65%.
Keep in mind that debt’s burden reduces the
net income.
Asset turnover, the second component of DuPont identity, measures how many times sales
cover the book value of assets in place. It indicates how efficient the company size is. An efficient company should need less investment
in assets to attain a given level of sales than an
inefficient one, thus benefiting from a reduction in structuring and financing needs. As the
numerator and the denominator of both quotients cancel each other out, the result shows
a good old ratio, return on assets (ROA).
Publication on CSR facts and trends
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Conducting a DuPont analysis of sustainable companies
29
Sales
-
Interests
-
Taxes
DuPont
Identity
Net Profit
Net Profit
Sales
Total Assets
Sales
x
x
Total Assets
Equity
ROA
ROE
Margin
x
Turnover
Taking net margin as a starting-point, we apply
the asset turnover formula. DJSIL companies’
turnover is significantly higher than their respective sectors, reaching a median of 0.67compared to 0.19. When combining the net margin
and asset turnover, we discover a return on assets of 5.75% for the sustainability champions
versus 1.26% for their respective sectors.
As a third component of DuPont identity we
are to determine the fraction of assets that
are in fact being financed by shareholders’ equity as opposed to other liabilities. We call leverage the ratio between total assets and the
book value of equity. It shows how many times
RSEARCH
x
Leverage
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
Operating Margin
= ROE
the total investment of a company outnumbers the equity in place. As long as debt is not
unsustainable -never a truer word spoken-,
the fewer the funds shareholders need to disburse -given constant profits- the more profitable their investments become. Therefore,
leverage confers an additional reward upon
return on assets, hence its name. This lever
functions like a turbo in a sports car. Once it
starts working, engine’s “regular” performance
is enhanced. As in motor racing, if such extra
power is not monitored and controlled, companies may go off track at the first bend, as we
have seen during the financial crisis.
Publication on CSR facts and trends
30
In the end, DuPont analysis sheds light on
the ability of sustainable companies’ business
model to generate higher returns. Considering that they benefit from higher net margins, adding more efficiency in the use of assets and a greater access to debt yields the
sustainability champions a superior return
against their peers.
RSEARCH
DJSIL
Sector
Operating Margin
13.27
9.50
Net Profit Margin
8.55
6.65
Asset Turnover
0.67
0.19
ROA
5.75
1.26
Leverage
3.44
2.63
ROE
19.79
3.32
Publication on CSR facts and trends
SUSTAINABILITY FOR FINANCIAL GEEKS IN FOCUS
When applying this last factor, it becomes evident that leverage amplifies ROA, increasing
returns substantially. In the case of the DJSIL,
leverage is 3.44 times, which produces a final
ROE of 19.79%. In contrast, their respective
sectors relay on a smaller levering power. A
leverage of 2.63 yields a ROE of 3.32%.
31
Publication on CSR facts and trends
June 2011 ı Nº 4
PROJECT DIRECTOR:
Jaime Silos
EDITORS:
Cecilia Williams
Germán Granda
Beatriz Berruga
Ricardo Trujillo
Ana Herrero
Iñigo Luis
Catherine Lambert
Laura Maure
Natalia Montero
DESIGN: Rafael Gimeno
Cover Image Credits: Diego Barbieri / Shutterstock.com
TRANSLATION: CELER Soluciones
Calle Zorrilla, 11 - 1º izquierda. 28014 Madrid
Tel. +34 91 522 79 46 - Fax +34 91 369 27 86
[email protected]
www.foretica.org
Sponsor