Valuation effect of ESG and its impact on capital structure: Evidence from Europe

In this study, we examine the valuation effect of ESG performance using a sample of 895 European companies. The misvaluation of the company is determined by the ratio of its market price to its true value. A true value calculation is based on two measures: first, on the analysts' forecasted price, and second, on residual income. We find that improvements in ESG profiles increase market prices in relation to their true value. An analysis of overvalued and undervalued stocks separately revealed that ESG performance further enhances the existing level of overvaluation. Conversely, it restores undervalued stocks to their true value for residual income measures of misvaluation. Alternatively, mispricing measured by analysts' forecasted price is significant only for undervalued stocks and the entire sample. Our analysis suggests that information asymmetry and market sentiment play a moderating role in the ESG-misvaluation nexus, suggesting that ESG is a friction to market efficiency. ESG-related misvaluations further impact capital structure through market timing practices, and the increased stability of CSR can be attributed to a marginal increase in equity issuance. We attribute this valuation effect to the demand effect associated with ESG investments. The findings are robust to alternative measures of estimation.