The Financial Challenge: Reconciling Social and Environmental Value with Shareholder Value
In the finance community, shareholder value has long been the performance metric of choice. But, is it possible to reconcile shareholder value with SEERS, a business perspective which aims to integrate social, environmental, economic responsibility, and sustainability factors into decision making? From a financial vantage point, the answer is a qualified yes.
In this article, we present an approach that incorporates components of SEERS into financial analysis and education. By focusing on those elements of SEERS with a clear connection to financial performance, including shareholder value, we can encourage socially responsible practices without sacrificing analytical rigor. We believe that such an approach is not only defensible but also reflective of the way social and environmental responsibility is viewed by leaders in many corporations. Matt Kistler, senior vice president of sustainability at Wal-Mart, supports this when he says “If this was not financially viable, a company such as ours would not be doing it” (Bhanoo 2010).
Finance theory defines the current value of any asset as the present value of the cash flows it is expected to generate in the future. There are two variables in this analysis—expected cash flows and a risk adjusted discount rate. Discounted cash-flow techniques—the most widely used tools for evaluating investments and valuing companies—are based on this simple concept. With discounted cash flow, two components can increase the value of a company today: one is an increase in the expected future cash flows (through cost reduction or revenue enhancements); the second is a decrease in the risk of those cash flows as proxied by the discount rate.
Thus for SEERS activities to create shareholder value, they must either increase future cash flows (profits) or reduce the risk of those cash flows. Some individuals might scoff at the need for such a direct connection, arguing that any socially responsible behavior is beneficial in general. However, most finance professionals are more pragmatic, and they would not only better understand, but hopefully endorse, SEERS activities with a clear link to incremental cash flow or risk reduction.
To facilitate analysis, we propose three categories to evaluate SEERS activities: cost savings; revenue enhancement; and risk reduction. As we discuss below, however, the delineation is not always clear and some SEERS activities may span more than one category.
The simplest way to increase profits is to reduce expenses. The link between SEERS and cost reduction can be direct or indirect. If achieved directly, that is, with no additional spending or investment, the benefits are obvious and unambiguous. SEERS activities that fall into this category include a switch to less expensive but more socially responsible production inputs. Examples of direct cost reduction include a newspaper publisher’s switching to recycled newsprint priced below virgin paper and a restaurant’s purchasing locally grown produce that is cheaper than the offerings of its usual distributor.
In practice, most SEERS choices have an impact on multiple-cost items and may involve significant investment. The savings in these cases are indirect. A common example of this is efforts to reduce energy used in heating, cooling, and lighting commercial buildings. This can be achieved in many ways, including insulation, smart controls, and compact fluorescent lighting. Each of these changes involves an upfront investment that yields future cost savings in the form of reduced energy consumption. The environmental benefit comes from reduced use of fossil fuels and fewer greenhouse gas emissions. For any of these investments, we can estimate future cost savings, use discounted cash flow techniques to weigh them off against the required investment, and make a decision based on the expected impact on shareholder value.
Another example of indirect cost savings can be found in the way companies package their products. Environmentally friendly packaging design can reduce material requirements, cut shipping and warehousing costs, and encourage recycling. For example, Procter & Gamble’s recent redesign of the Folgers coffee container reduces plastic consumption by 1 million pounds annually.
There are many examples where SEERS both reduces costs and enhances revenues. Wal-Mart attributed more than $100 million of its 2009 revenue to its decision to switch to recyclable cardboard when shipping to its 4,300-plus stores in the United States. Now, it sells the cardboard to a recycler rather than pay to ship the waste to a landfill (Bhanoo 2010). In this case, Wal-Mart reduces its disposal costs by switching to recyclable cardboard, which it then sells to generate new revenue. Even if the new cardboard is more expensive, the incremental cost is more than offset by the new revenue and the reduction in disposal costs. Wal-Mart estimated the 2009 environmental benefits as 8,600 fewer tons of cardboard in landfills and 125,000 trees saved (Wal-Mart Stores Inc. 2010, 13).
Another category of cost savings involves the intersection of SEERS and a company’s employees. The premise is that more-loyal employees save a company money by reducing turnover and increasing productivity. Lower turnover means reduced costs for hiring and training, while higher productivity improves profit margins. The first link between SEERS and loyalty is based on the idea that employees are less likely to leave socially responsible companies, which share their values, a claim borne out by survey data.*
As an example, Timberland combines both approaches by shutting down one day a year so all 5,400 employees can participate in company-sponsored philanthropy. It also allows workers one week off with pay each year to work with local charities, and it offers four paid six-month sabbaticals each year for employees to work at a nonprofit.
This is not inexpensive; the one-day shutdown alone costs the company $2 million. Timberland management believes that such expenditures help the company attract and keep the best talent, which benefits the bottom line. In the words of President and CEO Jeffrey Swartz, “People like to feel good about where they work and what they do.” (Pereira 2003).
Loyalty and productivity also may improve at companies with socially responsible human resource (HR) policies, which might include paying above-market wages; providing discretionary benefits such as health care and retirement; offering such workplace perks as free lunch, on-site gyms, and child care; and ensuring safe and fair working conditions globally. Starbucks, for example, realized early on that its employees (called “partners”) were critical to creating its competitive advantage, the “customer experience.” Being able to attract, train, and retain new employees also was critical to its rapid growth plans. To accomplish this, Starbucks pays above-market wages and offers health and dental benefits, vacation time, a 401(k) plan, and stock options to even part-time employees. The company also provides numerous opportunities for advancement, knowing that its typical hire will want new challenges. Does it work? Turnover of Starbucks baristas is 80 percent annually, whereas the industry average for quick-service restaurants is 200 percent (Weber 2005). Companies such as Timberland and Starbucks believe their investment in CSR and socially responsible HR practices yields tangible financial benefits by creating a loyal and productive workforce. The question with respect to shareholder value is whether those benefits outweigh their costs.
For many firms, the financial goal of SEERS may be to increase revenue. As with cost reductions, the link between SEERS and revenue can be direct or indirect. The direct link occurs when customers pay a premium for the socially or environmentally responsible characteristics of the company’s products. When companies pursue CSR to attract new customers, the connection to revenue is indirect. The indirect approach has a more tenuous connection to profitability and shareholder value. Consumers pay a premium for socially responsible products for many reasons. In some cases, they believe the products are superior. For example, some consumers believe organic produce and free-range meats are healthier and taste better, which justifies a higher price. In other cases, the products are of equal quality or functionality but have been sourced in a more environmentally friendly manner or provide social or environmental benefits in use. The electricity from a wind turbine is identical to the electricity from a coal plant; however, generating the former does not produce CO2 or contribute to climate change.
For SEERS-based revenue enhancement to create shareholder value, the additional costs of social responsibility must be offset by the premium customers are willing to pay. Balancing these considerations can be challenging. For example, in 2008, Costco and Sam’s Club introduced a newly designed 1-gallon milk jug. The square container carried significant environmental benefits, including easier stacking, storage, and transportation. It also did away with the need for traditional milk crates. The benefits included significant labor savings, less fuel and water consumption, and a lower price to consumers. Consumers initially rejected the new jugs, however, claiming they were difficult to pour. The jug was subsequently redesigned, and in-store pouring classes were introduced. The point is that consumers will not accept reduced functionality as a tradeoff for improved environmental product characteristics.
Contrast this example with Dutch Boy’s 2002 introduction of the Twist & Pour paint container. The new container was completely recyclable and stacked more efficiently for transportation and storage. It also provided tangible benefits to the consumer, including an integral pouring spout, a twist-off lid that better preserved the paint, and an easy-to-grip handle. Even though the container cost $2 more than a traditional metal paint can, sales at Dutch Boy tripled in the first year (Bishop 2008). By improving both performance and environmental characteristics, Dutch Boy was able to increase its total revenues. Another revenue-enhanced component of SEERS may be the ability to generate additional business from existing customers or to attract new ones. One method of indirect revenue enhancement is cause marketing, which Wikipedia (2010) defines as a type of marketing involving the cooperative efforts of a for-profit business and a nonprofit organization for mutual benefit.
An early example of this was the 1983 partnership between American Express and the Statue of Liberty–Ellis Island Foundation. American Express pledged a one-cent donation toward the Statue of Liberty renovation for each transaction made with an American Express card and $1 for each new card application. The campaign included $4 million in advertising and resulted in $1.7 million being donated toward the $62 million renovation. More importantly for the company, use of American Express cards rose by 28 percent in just the first month, compared with the previous year, and new card applications increased by 45 percent (Adkins 2003, 670). In this example, the implications for company profitability and shareholder value could readily be estimated.
Other ways of engaging SEERS to indirectly increase revenue include charitable giving and involvement in the local community. In some cases, these activities may be connected to the company’s product or service. For example, in 2010 Aéropostale donated 15,000 unsold coats from the previous season to nonprofit Cradles to Crayons, which provides clothing to children in need. The benefits of donating these coats exceeded the incremental revenue that Aéropostale might have made from selling marked-down, off-season coats.
In other cases, such actions may have no direct connection to the company’s products or revenue, but they help build the company’s reputation which, during a longer period of time, might help retain existing customers and attract new ones, indirectly increasing revenues. Examples of this type of activity include McDonald’s Ronald McDonald House and Goldman Sachs’s 2008 pledge of $100 million to “10,000 Women,” a global initiative delivering business education to women in developing countries. Cynics might argue that some of these activities are meant to repair rather than build reputations, but the goal is consistent: to enhance the company’s image in the eyes of employees, customers, investors, and other stakeholders.
In considering the revenue-enhancement opportunities of SEERS activities, organizations must be cognizant that there is a limit to the premium that customers are willing to pay for socially conscious goods and services. The tradeoffs inherent in such decisions can create conflicts with other stakeholders and core aspects of a company’s strategy. For example, Wal-Mart complained about the high prices associated with using renewable energy and was concerned that the costs would have to be passed on to consumers, threatening the company’s “always low prices” mantra (Ailworth 2010). Merck, which in partnership with the Gates Foundation launched an initiative in 2000 to improve HIV/AIDS treatment in Botswana, had to balance the R&D costs of developing new drugs and the need for patent protection with the very real social crisis HIV and AIDS were causing in Africa.
The final financial classification of SEERS initiatives is that of reducing risk. If the volatility of a firm’s cash flow decreases, so should its cost of financing (Luo and Bhattacharya 2009). Reducing the discount rate in any discounted cash flow analysis increases the current value of future cash flows. Even if it requires new investment or additional expense, a sufficiently large reduction in risk can increase shareholder value.
The first way SEERS can reduce risk is by heading off potentially expensive regulation and taxation. Consider the American Beverage Association’s recent television and print ads showing Coca-Cola, Pepsi, and Dr Pepper employees removing full-calorie soft drinks from school vending machines. The campaign (American Beverage Association, n.d.) touts the collaborative effort among fierce industry rivals and claims, “Together, we’ve reduced beverage calories in schools by 88 percent.” What the ads fail to mention are the recent efforts at both the federal and state levels to impose new taxes on sugar-laden beverages. The taxes would raise revenue that would be used to offset the contribution of these drinks to obesity-related health problems. Kevin Keane, senior vice president of public affairs at the American Beverage Association, summarized the industry’s perspective as follows: “You’re always in a far better position to be on offense than on defense all the time, and our companies recognize that and are doing bold things in the public policy arena that others will follow.” (Zmuda 2010).
In other cases, the risk is not of additional regulation or taxation but to the company’s reputation. Nike has had to respond to questions from customers and activists about their social and environmental impacts. When a 1996 column in The New York Times highlighted the conditions under which Indonesian women were producing Nike products, the company found itself at the center of a public relations nightmare (Herbert 1996). Labor groups protested Nike’s practices and accused it of hypocrisy, noting that the company was in the midst of an ad campaign that touted sports and exercise as a path to female empowerment. Brewing boycotts of Nike products by consumer groups increased the risk considerably. As a result, later in the year the company created a new department to monitor compliance with labor standards by its supply-chain partners. By 1998, Nike had established SEERS initiatives connected to its core business functions in response to the labor crisis and the potential damage to its reputation (Kytle and Ruggie 2005).
The examples of cost savings, revenue enhancement, and risk reduction in this article suggest that organizations can connect SEERS to financial value creation. Yet, as leaders use these models, they need to be cautious to avoid value-destroying behavior that occurs when they unilaterally pursue social initiatives that competitors eschew. This type of activity can put an organization in a vulnerable position in either the product or capital markets. Coining the term supercapitalism, Robert Reich (2008, 10) argues, “Competition is so intense that most corporations cannot accomplish social ends at a cost to their consumers or investors, who will otherwise seek and find better deals elsewhere.” Reich cites numerous examples of companies whose SEERS activities had to be scaled back in the face of declining financial performance. These include Levi Strauss, which almost went bankrupt due to its commitment to domestic manufacturing, and Marks & Spencer, a perennial favorite for its worldwide labor standards, which became the target of a hostile takeover in 2004. The key is that in a competitive marketplace, companies must pay attention to both SEERS and profitability or risk losing both.
In summary, in order to remain viable, organizations must consider how SEERS creates value for both their customers and their shareholders. To do so, they need to be aware of the competitive landscape and effectively communicate their social and environmental activities and anticipate customers’ reactions to price increases or product functionality changes. Activities that reduce costs or directly increase revenues in a predictable way will yield the most immediate and tangible financial benefits. Furthermore, the analyses of the cash flows should consider how these activities increase or decrease the risks.
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