The impact of a firm’s engagement in socially responsible activities can affect its valuation and profitability. In certain situations, such activities can have a positive effect on firm value.
The authors explore the link between corporate social responsibility and a company’s financial performance. They develop and test variants of a model that considers the effect of corporate resources spent to support socially responsible activities and find that, in certain situations, such engagement increases firm value.
How Is This Research Useful to Practitioners?
The effects on corporate social responsibility of a company’s valuation in terms of cash flows, survivability, and cost of capital is the focus of the authors’ research. They demonstrate how outlays for these activities in certain situations may benefit the firm.
The authors’ work affirms much of the empirical evidence that suggests there are value-enhancing benefits of corporate social responsibility, including profit maximization and sustainable value creation for shareholders. At the same time, socially responsible activities benefit other stakeholders. Beyond a certain point, the resulting diminution of resources along with decreased cash flows can negatively affect valuation. There is no one “sweet spot” at which corporate social responsibility expenditures maximize value. Industries, their firms, and the competitive environments where they operate all differ.
Using two models, the authors explore the relationship between corporate social responsibility spending and firm value. The first model addresses how corporate social responsibility affects the cost of capital and the discrete probability distribution of survival. The second model, by contrast, assumes a dynamic probability distribution of survival and introduces the direct effect of corporate social responsibility expenses on the size of cash flows. The authors use hazard and survival functions to measure the benefits for shareholders in terms of enhanced value and for the firm and its clients through increased company longevity.
Valuation experts, as well as those portfolio managers and analysts who focus on ESG (environmental, social, and governance) investment, will find the authors’ conclusions useful fodder for more in-depth research and analysis.
How Did the Authors Conduct This Research?
The authors review four strands of the literature: research that considers (1) the impact of corporate social responsibility on company performance, (2) financing costs, (3) risk profiles, and (4) valuation. Although they are each informative, the studies arrive at some disparate conclusions. Corporate social responsibility expenses tend to increase at firms with rising performance, but not vice versa. Financing costs benefit from corporate social responsibility with a low level of such activities. Corporate social responsibility may enable a firm to do well while “doing good.” How much cash flows improve relative to outlays and the extent to which the firm is less likely to default on its obligations and reduce its cost of capital affect firm value. The authors examine this issue through two models.
Corporate social responsibility can cut both ways: positively, if such engagement increases demand for the firm’s goods and services, or negatively, if such benefits are not compensation enough for expenditures that reduce earnings and cash flow. The authors test this relationship by running simulations of the model under various scenarios that consider how corporate social responsibility expenditures as a percentage of firm operating expenses affect the probability of firm survival. Applying a robustness test, the authors adjust parameters to keep initial values of survival probability, cost of capital, and cash flow growth the same but constrain the limits in magnitude of improved survivability and decreased capital costs that would result from corporate social responsibility expenditures.
The authors’ second model builds on the first; they use a similar methodology but also investigate the impact of corporate social responsibility expenditures on the probability range of company survival or collapse. To accomplish this task, they use a hazard function to gauge how quickly a firm may go out of business as a way to determine its survivability. The authors run thousands of simulations at varying levels of corporate social responsibility expenses.
Both models identify circumstances in which corporate social responsibility enhances shareholder value. Beyond a certain point, such outlays may detract value and render the socially responsible firm less competitive than peer firms that do not commit to social responsibility. The ideal level of socially responsible expenditure is most likely a function of the firm, industry, and competitive environment.
Who benefits from corporate social responsibility, and how can the benefit be measured? Drawing from a large body of literature on a well-researched subject, the authors focus on the valuation benefits to firms that engage in corporate social responsibility. Their simulations seem to affirm the merit of such activities yet also acknowledge their potential for value detraction beyond a certain level of expenditure. They do not attempt to solve for the optimal level of socially responsible activities that would benefit firms the most. Industry and firm characteristics and markets make this a somewhat difficult and intractable issue. A possible area for additional research would be to explore the issues the authors address in a more global context.