As both an idealist and someone who takes pride in making data-driven business decisions, the question is raised: Is it possible for those two perspectives to be aligned as a philosophy of investing?
The unfortunate reality is that many think these two modes of thought are mutually exclusive. There is a notion that we might have to sacrifice our principles to yield positive financials returns. However, this does not have to be the case. Sustainable investing, for example, provides a way to balance socially responsible considerations with making data-driven business decisions.
To many, sustainable investing implies a strategy that seeks out companies with socially conscious objectives, compromising financial returns in pursuit of a greater good. Others acknowledge that socially conscious objectives may not need to undermine financial returns.
Yet, from an analytical lens, investing in companies with sustainable practices — such as no environmental impact, diversity, generous employee benefits and low employee turnover — does and should maximize risk adjusted long-term financial returns.
Sustainability, in many cases, is often a proxy for better-managed companies, and as an elite company, it’s their intention to provide shareholders with greatest possibility for risk adjusted long-term financial returns.
While risk is lowered with sustainable practices, price is of course a factor. The best investment is the most attractive ratio between risk and reward. Even a low growth company with low risks may be a good investment at the right price.
Understanding why sustainable investing maximizes risk adjusted long-term financial returns does not require the embrace of idealism or a strategy of hope. Instead, it calls for a fundamental understanding of how markets value business based on discounted cash flow analysis, or DCF.
A DCF is a customary approach for valuing companies and involves two considerations: 1) projecting the future cash flows a business is expected to generate and 2) discounting those cash flows and a terminal value to the present day to calculate their current value.
The future cash flow is projected by analyzing unit growth, price and cost structure. The process also involves the application of a discount rate to those future cash flows. Simply put, $100 in five years is worth less than $100 today, and $100 in 10 years is worth even less and so on. Analysts calculate exactly how much those future dollars are worth today by applying them at a discount rate.
The second component — discounting to the present future cash flows to determine their current value — is where analysis reminds us that through sustainable investing, financial returns are optimized. A discount rate is the combination of the cost of money in a marketplace and the future uncertainty to the predictability of cash flows. The cost of money is common across all firms in a given industry in a given market.
Future uncertainty is where sustainability plays a key role. The less uncertainty we apply to the future, the more value the future becomes in the present. Consider two businesses in the same industry that are both projected to generate $10 million of annual cash flow in five years and $20 million of annual cash flow in 10 years. Surely those businesses are worth the same amount today, right? Not necessarily.
Suppose one employs business practices making sustainable methods that generate a lower or, even better, no impact on the environment than the other business. Suppose also that same former business has a better-treated workforce than the latter business.
The business with practices that appeal to our senses of virtue also have much less uncertainty around their future financial performance because — measured correctly — sustainable practices, by definition, reduce future uncertainty.
Sustainability is a force that reduces future uncertainty. As such, it logically follows that sustainability makes future cash flow more valuable in the present. It becomes clear that when evaluating two comparable businesses, the one with future cash flow that is valued more highly in the present is the better investment due to its sustainable behavior. Through DCF, we can prove that sustainable investing is not just “nice-to-have” in a portfolio, it is a “must-have” for an investor interested in maximizing risk adjusted long-term financial returns.