The role of valuation multiples in transmitting ESG changes to stock returns

Abstract

In this study, the main objective is to discuss the role of valuation multiples (P/E, P/B, and EV/EBITDA) in transmitting Environmental, Social, and Governance (ESG) score changes to stock returns in the U.S. equity market. The major question is whether investors who do not monitor ESG scores directly nonetheless receive ESG-related information indirectly, through movements in these valuation multiples. The sample comprises of 130 S&P 500 firms (excluding the Financials and Real Estate/REIT sectors) over the period 2005-2024, covering 2,388 firm-year observations. The empirical design proceeds in two stages. Stage 1 comprises two parts: Stage 1A uses pooled OLS regression to test the effect of ESG score changes (ΔESG) on each valuation multiple (H1), and Stage 1B uses firm-level time-series regressions to construct an "M-indicator" that classifies firms as having ESG-sensitive (M = 1) or ESG-insensitive (M = 0) multiples. Stage 2 then uses pooled OLS regression to test how ESG information is transmitted through these multiples to the cumulative abnormal return (CAR[0, +5]), computed using the Carhart four-factor model (H2). The findings offer some support for the hypotheses, with the main observation being an asymmetry between updates in fundamental valuation and the transmission of prices. In Stage 1A, EV/EBITDA reacts most directly and positively to ESG enhancements, aligning with its evaluation of the entire firm regardless of capital structure, whereas P/B reacts asymmetrically, responding negatively to ESG declines. In Stage 2, P/E acts as the main channel conveying ESG information to short-term returns for firms sensitive to ESG (M_PE= 1), while EV/EBITDA fails to deliver a noteworthy short-term price signal. These findings indicate that the ESG-pricing channel is firm-specific rather than market-wide: the market updates fundamental value through EV/EBITDA, but the signal that reaches short-term returns travels through P/E, arguably the most widely followed equity multiple. They suggest that, for firms already identified as ESG-sensitive, investors can monitor P/E movements as a sign of ESG impact; that corporate issuers may influence the short-term market reaction more effectively by aligning ESG communication with EPS guidance; and that one-size-fits-all ESG disclosure policies may have limited impact through this channel, signaling more targeted approaches.