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Is This the Investing Metric of the Future?

By Charlene Rhinehart, CPA - Apr 23, 2021 at 8:32AM

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There's something beyond profits that's causing investors to take a second look at their investment choices.

You don't have to go far to find a list of trending investing topics these days. Investing has pretty much gone from geek to chic overnight, ushering in a league of investors who are waiting for their stocks to explode and make them rich.

But as ravishing as the income potential can be for an investor, there's another measure of company performance that's gaining traction. It's called ESG (environmental, social, and governance) and it's driving the way stakeholders assess the value of today's companies. 

Here are a few insights to help you become more acquainted with ESG. Take note: This could become the socially responsible buzzword of the decade. 

Businessman watering plant.

Image source: Getty Images.

Making sense of ESG

ESG is an investing metric that's becoming more important in the development of an investment portfolio. It takes into account a socially responsible approach to investing, blending together core factors that could potentially impact a company's longevity. 

Let's say you're analyzing a few stocks that may be a good fit for your portfolio. The stocks have checked the boxes on some of the most popular financial metrics: price-to-earnings ratio, price-to-book, return on equity, payout ratio, and debt-to-equity. But now you want to go beyond the numbers and measure the long-term impact that these companies can have on society. That's where ESG comes in. 

Essentially, ESG broadens the scope of how you make investing decisions. If you're only looking at a company's current financial health, you may miss the mark on how a company's stance on economic, social, and governance factors can obliterate its future profit potential. ESG provides a lens to help investors measure a company's sustainability efforts in accordance with factors that matter most to stakeholders. 

We'll break down the three slices of the ESG pie next so you can better understand this holistic approach to investing. 

Diving deeper into the components of ESG 

Socially responsible investing has been around for decades but ESG is picking up at lightning speed right now. Let's pull back the layers on how each criterion is typically used in the evaluation process for ESG investing. 

The environmental component of ESG focuses mainly on a company's adherence to external factors that could influence a company's sustainability. For this one, think about the company's impact on the environment and carbon footprint. Also, consider climate change and the raw materials used during the production process. 

The social piece of the ESG puzzle has been a bit more challenging for some companies to grasp. But there are investors who are measuring social goals such as a company's diversity initiatives, hiring practices, and community impact to determine how well they rank on the social scale. 

Last, we have governance. There is data that suggests that companies that nail the governance piece of ESG produce better returns. There have been standards around this for quite some time, leveraging systems and data points that enable a company to serve shareholders in the best way possible. This takes a look at things like board structure and executive compensation. 

Going beyond the numbers 

There are some investors that may be quick to dismiss ESG as a relevant investing metric at this time. That's understandable. Earnings have always dominated the investing scene while socially responsible investing has typically been gently sprinkled within investing decisions.

But the tide is quickly changing and what investors expect from the companies they invest in is evolving as well. Even legendary investor Warren Buffett warned investors to avoid buying a stock solely based on price expectations. He's a firm believer in assessing long-term value and understanding the companies you invest in. In a letter to shareholders, Buffett wrote, "If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes."

In this new environment, investors may be assessing long-term value and what they're willing to hold on to based on ESG. 

ESG could become the new company report card 

Investors' appetite for companies that align with the goals of the greater good is growing. It's not just about income anymore; it's about impact. The ESG investing metric is holding companies to a new standard of excellence that is quickly expanding the vision of bottom-line goals. 

If you're interested in using an ESG focused lens to evaluate your investments, the good news is that you don't have to start from scratch. You can review ESG scores and ratings from independent firms to successfully integrate sustainability metrics into your financial goals. Start diving into the world of ESG now because there's a pretty good chance that it's here to stay. 

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