International Review of Economics and Finance 91 (2024) 19–35

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International Review of Economics and Finance

journal homepage: www.elsevier.com/locate/iref

Valuation effect of ESG and its impact on capital structure:

Evidence from Europe
Muhammad Arif Khan a, M. Kabir Hassan b, *, Maria Pia Maraghini c,
Biancone Paolo d, Giorgio Valentinuz e
a
Research Fellow in Corporate Finance, Department DEAMS, University of Trieste, Italy
b
Department of Economics and Finance, University of New Orleans, USA
c
Department of Business and Law, University of Siena, Italy
d
Department of Management, Università di Torino, Italy
e
Department DEAMS, University of Trieste, Italy

A R T I C L E I N F O A B S T R A C T

JEL classification: In this study, we examine the valuation effect of ESG performance using a sample of 895 Euro­
G1 G3 M21 G12 pean companies. The misvaluation of the company is determined by the ratio of its market price
Keywords: to its true value. A true value calculation is based on two measures: first, on the analysts’ fore­
ESG performance casted price, and second, on residual income. We find that improvements in ESG profiles increase
Overvaluation market prices in relation to their true value. An analysis of overvalued and undervalued stocks
Undervaluation
separately revealed that ESG performance further enhances the existing level of overvaluation.
Capital structure
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 mar­
ginal increase in equity issuance. We attribute this valuation effect to the demand effect associ­
ated with ESG investments. The findings are robust to alternative measures of estimation.

1. Introduction

The sustainable performance of European companies is not just a theoretical commitment but also a tangible and growing reality,
supported by reliable industry data and market trends. European businesses are aiming for a combination of responsible business
practices, resource efficiency and financial success, contributing to a more sustainable and resilient business landscape. Notably, In the
principal European markets, ESG metrics are currently integrated into the incentive structures of 90% of companies, marking an
elevation of 11 percentage points from the preceding year (Schoenthal & Summers, 2023). This signifies the earnest commitment of
companies to the principles of Environmental, Social, and Governance (ESG).
A growing number of European companies are investing in renewable energy initiatives. Countries like Germany and Denmark are

* Corresponding author.
E-mail addresses: [email protected] (M.A. Khan), [email protected] (M.K. Hassan), [email protected]
(M.P. Maraghini), [email protected] (B. Paolo), [email protected] (G. Valentinuz).

https://doi.org/10.1016/j.iref.2024.01.002
Received 23 April 2023; Received in revised form 15 November 2023; Accepted 1 January 2024
Available online 2 January 2024
1059-0560/© 2024 Elsevier Inc. All rights reserved.
M.A. Khan et al. International Review of Economics and Finance 91 (2024) 19–35

leading the way in wind energy production, with wind constituting a large percentage of their energy mix (Duffy et al., 2020). The
European auto industry is also making significant advances in converting to electric vehicles, allowing carbon emissions to be reduced
(European Enviromental Agency, 2016). Companies with robust sustainability practices in Europe are attracting substantial in­
vestments. In a notable example, Unilever, a British-Dutch consumer goods company renowned for its commitment to sustainability,
has consistently outperformed industry benchmarks. Its sustainable living brands, including those focused on environmental and social
impact, have demonstrated a growth rate over 50% faster than the rest of the business (Unilever, 2020).
On the other hand, investors are now actively factor in ESG considerations when making decisions, seeking alignment with sus­
tainability objectives. Over the last decade, the European Securities and Markets Authority (ESMA) has seen an increase in funds
incorporating ESG-related language, which will account for 14% of EU assets under management (€974 billion out of a total of €6.8
trillion) in 2023, compared to 3% in 2013. The surge accelerated after the 2015 Paris Agreement, peaking from 2018 to 2022, though
the creation of new ESG products slowed in 2023. Notably, 1356 funds, representing 4.6% of EU-based actively managed funds, have
added ESG terms to their names since 2018, with a notable increase in 2021 and 2022, emphasizing the growing integration of
sustainability language in the financial sector (Mark, 2023).
Globally, more than a third of the estimated $140.5 trillion will be invested in environmental, social, and governance (ESG) assets
by 2025, with Europe accounting for more than half of those assets (Hamrouni et al., 2020). In addition, regulatory initiatives, coupled
with economic transitions towards sustainability, increase the demand for companies with high ESG ratings. In contrast, ESG-based
screening limits investment opportunities by screening investments that do not meet certain criteria (Borgers et al., 2015). The
confluence of a growing interest in sustainable business practices and a restricted investment pool can have an effect on the stock
market price efficiency of these businesses. As a result of the current "demand effect" of sustainability, we believe that share prices have
soared highlighting ESG as a friction to market efficiency. Therefore, this article aims to evaluate whether the hegemonic "demand
effect" of sustainability has any bearings for the pricing mechanism of the companies. Moreover, companies with strong ESG ratings are
less leveraged, indicating a potential impact on their capital structure.
This study offers a two-fold contribution. First, we contribute evidence from a European context to the existing literature on the
relationship between ESG and pricing efficiency. Furthermore, we extend the work of Bofinger et al. (2022) by evaluating the entire
sample of firms using dummy variables rather than analyzing only the top 20% and bottom 20% as overvalued and undervalued firms,
respectively. Mispricing is defined as the ratio of market price to fair value, where overvalued firms have a mispricing ratio over one,
and vice versa. Using the Refinitiv database, we collected data on our sample firms from 2008 to 2019. Our findings suggest that ESG
factors play a significant role in the mispricing of EU companies. The sustainability of a company enhances its market value in relation
to its intrinsic value. Moreover, our findings indicate that ESG promotes overvaluation and reduces undervaluation among segmented
samples of overvalued and undervalued stocks. Furthermore, we demonstrate that market sentiment and information asymmetry
moderate the relationship between ESG and mispricing, illuminating ESG’s role as a market friction.
Additionally, we extend the scope of the investigation by examining the impact of ESG performance on capital structure through
the mispricing channel. A market overvaluation provides financial managers with an opportunity to time the market. Our results
indicate that, in general, European companies adhere to the pecking order theory of capital structure but high-ESG enterprises
anticipate the overvaluation of equity markets caused by enhanced ESG performance and issue equity. Alternatively, it also shows that
companies typically use equity financing for CSR projects instead of debt in order to match cashflow timings that can be one of the
determinants of enhanced financial stability of high-ESG firms.
The paper’s structure is as follows: Chapter 2 presents the literature review and hypotheses, Section 3 discusses the data and
methodology, Section 4 presents the analysis results, and Section 5 provides the conclusion.

2. Review of the literature and development of hypotheses

2.1. ESG and misvaluation

Corporate social responsibility (CSR) commitments and investments are widely studied; however, scholars have differing opinions
about how they affect shareholder and stakeholder wealth. On the one hand, Friedman (2007) contends that CSR initiatives in financial
management should prioritize maximizing shareholder profits. However, some investors are skeptical that a firm’s ESG investments,
which may not have a direct impact on financial performance, could adversely affect profits and value (Friedman, 1970; Fuadah &
Kalsum, 2021).
In contrast, Freeman (1984) argued that corporations must consider the interests of all stakeholders. From a resource dependence
perspective, a company’s success depends on its ability to satisfy key stakeholders since resource extraction is reliant on a wide range of
stakeholders. Therefore, CSR activities should lead to value-added outcomes. Enterprises that prioritize stakeholder concerns receive
support and resources (Deng et al., 2013). For instance, a CSR initiative targeting primary stakeholders generates exchange capital,
such as brand and employee loyalty, and reduces idiosyncratic risk, thus affecting valuation. Conversely, a CSR initiative aimed at
secondary shareholders generates moral capital, such as social consent and leniency, which prevent stakeholders from imposing
punitive sanctions in the event of a negative occurrence (Lin & Dong, 2018).
CSR initiatives have been studied from the perspective of cost of capital in recent research (Bae et al., 2019). Furthermore, ac­
cording to stakeholder theory, several researches contend that companies engaged in CSR create long-term shareholder value (Nguyen
et al., 2020) even though stock markets undervalue CSR in the short term (Fernández-Guadaño & Sarria-Pedroza, 2018). A company
disregarding its social responsibilities may negatively affect its long-term shareholder value due to potential reputational damages or
litigation costs (Renneboog et al., 2008). Based on the analysis of 1000+ studies on ESG and financial performance, Aybars et al.

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M.A. Khan et al. International Review of Economics and Finance 91 (2024) 19–35

(2018) concluded that no consensus exists regarding causality and whether CSR is priced on capital markets, despite many studies
suggesting that CSR positively impacts financial performance.
In addition, little research has been conducted on the effect of CSR activities on market efficiency. Environmental, social, and
governance preferences may be associated with market inefficiency. According to Renneboog et al. (2008), socially responsible in­
stitutions (SRIs) are less likely to buy or sell undervalued or overvalued stocks. Since SRIs are concerned with ESG performance, they
pay more attention to it and ignore direct signals of firm value. From the perspective of investment behavior, Sangiorgi and Schopohl
(2021) and Starks et al. (2017) examined corporate social responsibility. In their study, they found that institutional investors with
longer time horizons prefer companies with high ESG ratings. The companies they hold in their portfolios are typically more patiently
handled by these types of investors. They are less likely to sell their stocks when they receive bad news or when the stocks in their
portfolios perform poorly. It is possible to explain these patterns of behavior by investors’ expectations that long-term wealth gen­
eration will compensate for short-term losses. Sustainable investors do not necessarily consider short-term valuation signals that are
negative for companies with high ESG ratings. According to research, socially responsible investors gain additional benefits in addition
to financial returns (Qiu et al., 2021). According to Ho et al. (2021) and Bofinger et al. (2022) socially responsible stocks tend to be
overvalued. The level of CSR of the companies may determine the extent to which this mispricing leads to market inefficiency. Based
on these findings, we suggest a link between ESG performance and stock price misvaluation.
Hypothesis 1. ESG performance affect the stock price misevaluation
There are several ways that a CSR program can contribute to a company’s financial success. For instance, Min and Galle (1997)
have demonstrated that CSR has a direct impact on customer evaluations of products and brands. It has also been shown that CSR
influences non-related customer decisions, such as the appraisal of upcoming products (Klein & Dawar, 2004). Because of the "hallo
effect" of CSR, consumers assume a company’s value and quality products will be enhanced by its environmental concern (Hong Inessa
Liskovich et al., 2015). Depending on the situation, it might even be possible to observe the halo effect in courtrooms. A halo effect
causes prosecutors to extrapolate from CSR to reduce penalties for companies that practice good CSR. Due to this prejudice that already
impacts consumers and prosecutors, investors may interpret a company’s CSR commitment as exceptional value.
Capital markets investors may attach a much higher value to CSR participation than to the actual value of the company. Investors
have increasingly expressed concerns about ESG in recent decades, resulting in a marked rise in socially responsible investments
worldwide (Renneboog et al., 2008). It is now more relevant than ever for investors to engage in sustainable investment. ESG funds
attracted more inflows than comparable products without ESG designations, according to Białkowski and Starks (2016). Hartzmark
and Sussman (2019) found that low-sustainability funds were experiencing net outflows, while high-sustainability funds were expe­
riencing net inflows. Customers who value sustainability and avoid assets with low ESG ratings might expect their asset manager to act
on their behalf. Ultimately, sustainable investing leads to inefficient pricing (Starks et al., 2017).
Although we have already argued that ESG can influence mispricing, such mispricing may take either the form of overvaluation
(market value is greater than true value) or undervaluation. For this reason, the real impact of ESG on valuation needs to be distin­
guished in both situations. As sustainable investing becomes more relevant, investors will likely direct capital to investments with high
ESG ratings, resulting in higher misvaluation ratios regardless of current misvaluation levels. This would exacerbate existing over­
valuations if the market price continues to diverge from the true worth of the firm. ESG participation and higher capital attraction are
expected to increase market valuations of undervalued stocks. Consequently, the deviation from the true value will decrease, leading to
a decreasing undervaluation. This led us to hypothesize:
Hypothesis 2(a). ESG performances further escalates the existing level of overvaluation
Hypothesis 2(b). ESG performance recede the existing level of undervaluation
The lack of information asymmetry in the market may also contribute to ESG misvaluation. A company’s ESG disclosures in annual
reports increase capital markets’ access to all of its information and transparency (Luo et al., 2015). ESG information, on the other
hand, has already been shown to mitigate information asymmetry (Cui et al., 2018). Scholtens and Kang (2013) report a reduction in
earnings prediction bias when corporate social responsibility (CSR) is improved. This research suggests that CSR involvement im­
proves market efficiency by reducing information imbalances. In contrast to hypotheses 2(a) and 2(b), this would lead to a different
outcome, where an increase in CSR would cause a convergence between market and real value. In addition, it is examined whether
information asymmetry affects the CSR effect on value. Consequently, we estimate that if information asymmetry is reduced, CSR
involvement will reduce misvaluations of both overvalued and undervalued enterprises. As a result, we hypothesized that information
asymmetry between ESG performance and valuation plays a moderating role:
Hypothesis 3. Information asymmetry moderates the ESG-valuation nexus.
Companies and investors are becoming increasingly interested in ESG factors. There is increased attention being paid to sustain­
ability over the long term, as evidenced by research from previous years (Cao et al., 2021; Hartzmark & Sussman, 2019). Therefore, we
expect the impact of ESG on misvaluation to continue to grow over the next few years. The degree of public knowledge of sustainability
issues can also be taken into account when assessing a company’s long-term viability. There is evidence that the general public’s
awareness of this has affected the price of securities (Coelho, 2015; Shu & Chang, 2015). Public perception of sustainability efforts of a
company impacts a company’s value, as demonstrated by Serafeim (2020). He showed that firms with high sustainability performance
have benefited from an increased value premium over time. It is therefore expected to have a moderating effect on the
ESG-misvaluation link, as evidenced by the rising importance of ESG. As a result, we hypothesize that.
Hypothesis 4. Increasing market awareness of sustainability moderates the ESG-valuation link

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2.2. ESG and capital structure

There are several theories that attempt to explain why a certain type of funding is chosen by a company. But trade off theory,
pecking order theory, and market timing theory is more practical and applied theory that explains the rationale for capital structure
design of the companies in real world (Kaldor, 2015). Trade-off Theory claims that target debt levels are dependent on other elements
that are typical of the company. This implies that while a specific debt ratio may be appropriate for one company, it may not be optimal
for another. For example, firms with substantial taxable revenue to shield and solid, tangible assets should choose a larger debt ratio,
whereas less lucrative firms with riskier, intangible assets should choose a lower debt ratio and depend more on equity financing
(Brealey et al., 2020).
Whereas, the Pecking Order Theory suggest a hieratical approach to financing: management must first turn to their own resources,
usually retained earnings, followed by external resources, such as new loan issues, and finally, stock issues as a last resort (Brealey
et al., 2020). This theory highlights the importance of asymmetry of information, which refers to the fact that managers know more
about their firms than investors do. As issuing equity may transmit a signal into the market, the potential investor may believe either
the company’s stock is overvalued, or the company is having financial difficulties. This opinion will become stronger if dividend
payments suddenly decrease or increase (Brealey et al., 2020). Another important theory that is relevant in this regard is the theory of
market timing. Baker and Wurgler (2002) proposed a more rational explanation for capital structure design that says that capital
structure is the cumulative attempts of managers to time the equity market. This further implies that firm issue equity when their stock
is overvalued to benefit the long-term investor on the cost of new short-term investor that may exit any time.
One way to minimize the cost of funding is through the use of CSR practices. According to Verwijmeren and Derwall (2010), strong
employee well-being is linked to reduced equity costs, which results in significantly more equity financing for the business than for
enterprises with lower employee well-being. Companies that care about their employees are willing to go to significant lengths to avoid
bankruptcy, contrary to conventional wisdom. According to Kling et al. (2021), investments in employee relations, environmental
policies, and product strategies CSR make equity less expensive. Maama and Marimuthu (2021) further explains that as ESG per­
formances removes information asymmetry, reduces information costs and enhances analysts’ following and investor trust, which in
turn reduces cost of equity capital. The ESG performance and its impact on the cast of equity capital may vary with type of industry: for
example, food and beverage companies should collect and disseminate ESG performance data on food and drink quality, health, and
product safety, according to Raimo et al. (2021). For sensitive industries, environmental performance is material to hedge reputational
risk (Garcia et al., 2017). Investors place a high value on this type of information since it cannot be gleaned from public filings.
whereas another stream of literature suggests that CSR performance might increase the cost of financing (debt and equity) if the
investor believes that the disclosed ESG performance is exploited by insiders to serve their own interest (Johnson, 2020; Wang et al.,
2021).
We already discussed in detail the valuation effect of ESG performances in section (2.1). We believe that superior ESG performances
boost the overvaluation which in term provide an opportunity to the financial management to time the equity market and issue equity

Table 1
Geographical Distribution of the data.
Region Countries Noumber of Firms

Souther Europe Gibraltar 1

Greece 17
Italy 37
Malta 2
Portugal 8
Spain 45
Western Europe Austria 15
Belgium 25
France 83
Germany 84
Luxembourg 12
Netherlands 42
Switzerland 65
Eastern Europe Czech Republic 6
Hungary 3
Poland 25
Romania 11
Russia 4
Slovakia 11
Slovakia 3
Nothern Europe Denmark 24
Finland 25
Ireland 37
Norway 18
Sweden 58
UK 234
Total Number of Firms 895

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if they need financing for their positive NPV projects. Therefore, we postulated the following hypothesis:
Hypothesis 5. Firms with higher ESG performances issue equity if they have a financing deficit.

3. Sample description and research methodolgy

3.1. Description of data and variables

3.1.1. Independent variable – ESG performance

This study aimed to assess the effect of ESG performance on the valuation of European firms, as well as how it relates to their capital
structure. The study utilized a sample of 895 European companies and examined their ESG data extracted from the Asset 4 database
provided by Refinitiv from 2008 to 2019 for all available sectors. Please see Table 1 for the list of countries. It is noteworthy that Asset4
ESG scores have been widely accepted as a reliable proxy for sustainability performance, as demonstrated by ample empirical evidence
in the literature (Chiaramonte et al., 2020; Iannello, 2020). The Refinitiv ESG score assesses a company’s relative performance,
commitment, and effectiveness on issues related to environmental, social, and governance (ESG). Approximately 12,000 companies
have been rated, and time series data date back to 2002. In the publicly available reports, more than 500 ESG data points are extracted,
of which 186 are comparable. Resource use, emissions, and innovation make up the environmental pillar; workers, human rights,
communities, and product responsibility make up the social pillar; and management, shareholders, and social responsibility make up
the governance pillar. Pillar scores are rolled back to ESG scores which indicate a company’s ESG performance and transparency in
reporting ESG data. Scores between 0 and 25 indicate insufficient transparency and poor ESG performance. Scores between 26 and 50
indicate satisfactory ESG performance and moderate transparency; 51 to 75 indicate good ESG performance and above average
transparency; 75 to 100 indicate excellent ESG performance (Refinitiv, 2021).

3.1.1.1. Dependent variables-misevaluation measure. Inferences about the association between ESG performance and the misvaluation
hypothesis depend on the quality of our misvaluation proxies. In order to estimate the misvaluation of firms, we use two distinct
measures that have been extensively documented in the literature. Among these measures is the fair price estimated by the residual
income model which discounts back the abnormal earnings (Ohlson, 1995). Following Bofinger et al. (2022), we calculated the true
price using the residual income model as follows:
[ ROE ] [ ROE ] [ ROE ]
f (t + 1) − kei (t) ∗ Bi (t) f (t + 2) − kei (t) ∗ Bi (t + 1) fi (t + 3) − kei (t) ∗ Bi (t + 2)
Vi (t) = Bi (t) + i + i + (1)
1 + kei (t) [(1 + kei (t + 1)]2 [(1 + kei (t + 1)]2 ∗ kei (t)

Where Vi (t) is the true stock price, Bi (t) is the book value of the equity, kei is the cost of equity and f ROE
i (t +n) is the forecasted return on
equity. We followed Bofinger et al. (2022), Elliott et al. (2007) and Dong et al. (2006) and discounted back next three-year abnormal
earnings as perpetuity by assuming that residual earnings remain constant after three year.
Finally, we computed the misvaluation by the ratio of market price to true value as follows.
Pi,t
MV RES
i,t = (2)
Vi,t

Where MV RESi,t is the misvaluation, Pi,t is the market price of a stock i at time t and Vi,t is the true price of stock i at time t estimated by the
residual income model. A ratio greater than one indicates that market price is higher than true price, and the stock is overvalued. On
the contrary, a ratio less than one indicates that the stock is undervalued.
In spite of the fact that residual income model is a forward-looking approach to misvaluation, it computes a value too low because it
ignores growth opportunities and does not anticipate future risks. Therefore, as a measure of robustness, target price is also used as a
proxy for true price, which is an analyst’s projection of a stock’s future price. Despite not being a fundamental value, the target price is
a more direct measure of true price since it anticipates all growth opportunities and forward-looking systematic risk components (Da &
Schaumburg, 2011). Similarly, we measure misvaluation by the following equation.
Pi,t
MV TP
i,t = (3)
Vi,t

Where MV TPi,t is misvaluation measured through the ratio of market price to target price. The validity of our hypothesis does not require
that either the residual income model or the price target be a superior proxy; what matters is that both measures provide significant
additional information about the true price fluctuation beyond the market price (Dong et al., 2011). By using these two valuation
measures, we increase the reliability and robustness of our analysis. We extracted the data for the aforementioned residual income
model and target price from the Refinitiv database.

3.1.1.2. Dependent variable-capital structure. In order to test our hypothesis about the impact of misvaluation on capital structure due
to ESG performance, we regressed debt change against ESG performance. The change in debt represents net changes in cash flow due to
the changes in the level of debt of a company. To ensure further robustness, we repeated the same regression with the changes in the
level of equity.

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M.A. Khan et al. International Review of Economics and Finance 91 (2024) 19–35

3.1.1.3. Moderator variables. In our study, we hypothesized that information asymmetry and market sentiment moderate the rela­
tionship between corporate ESG performance and market valuation. Google trend is used as a proxy for market sentiment, which has
been well documented in the literature estimates that Google dominates the search engine industry with a market share of 85.55
percent. This is the first publicly accessible big data platform that offers users the ability to see how popular specific keywords are?
Google Trends is an effective tool for tracking stock market sentiment. It is strongly correlated with stock returns and abnormal trading
volumes and can be used for future stock market forecasting (Simionescu & Raišienė, 2021; Johnson, 2012). We therefore extracted
data from Google Trends’ SVI between 2008 and 2019 to assess the moderating role of market sentiments.
Our initial search for the term "ESG investing" turned up relatively few observations for most sample countries and no data for
Malta. We then searched the topic “Sustainability” and averaged out the monthly data in order to arrive at an annualized value.
Information asymmetry is the second moderating variable. To measure information asymmetry, we use bid-ask spreads (Bofinger
et al., 2022). This measure represents the daily averages of the bid-ask spreads. We followed Bofinger et al. (2022) and calculated
information asymmetry through the following formula:
Information asymetry = (Ask − Bid)/((Ask + Bid) / 2) (4)

In general, the larger the information asymmetry, the wider the bid-ask spread in the underlying stock. Shareholders with broad bid-
ask spreads are likely to possess divergent levels of information.

3.1.1.4. Control variables. Following a careful review of the literature, this study includes several control variables that have been
identified as relevant to the misvaluation. Earnings per share represents the income available to common stockholders and is relevant
for misvaluation since reported earnings carry information that the market uses to determine the company’s value (Kormendi & Lipe,
1987). The leverage ratio, defined as the total liabilities divided by the total asset, analysts’ coverage (Cheng & Tzeng, 2011) and the
size, calculated as the log of the total asset. We also used capital expenditures (Karim et al., 2021) and the market-to-book ratio as
control variables to account for growth opportunities (Chen & Zhao, 2006).

3.2. Empirical methodology

We employed a fixed effect model with lagged dependent variables to control country heterogeneity in the relation between
misvaluation and ESG performance, which may be the result of differences in unobservable characteristics across firms or reverse
causality (Manita et al., 2018). For instance, overvalued firms are more profitable and may have more funds for CSR investments. This
is why the inclusion of lagged values of dependent variables will account for the possibility that misvaluation may depend on historical
events. Therefore, we estimated the following fixed-effect model, with lagged-dependent variable:
Yi,t = β1 Yi,t− 1 + β2 ESGi,t− 1 + β3 Xi.t + ϵi,t (5)

Where Yi,t represents the depended variable, which is misvaluaion measures, Yi,t− 1 is the lagged value of depended variable1included
to incorporate the fluctuation in misvaluation because of the past event. The ESGi,t− 1 is the lagged value of ESG, So β2 will estimate the
impact of ESG performance on the company misvaluation. The vector Xi.t captures the effect of control variables on misvaluation and
ϵi,t is the error term. Equation (5) is estimated for three models: first, all sample companies to capture the overall behavior, second,
overvalued firms to determine whether ESG performance pushes overvalued firms further from their true value, and third, under­
valued firms to ascertain whether ESG performance moves undervalued firms closer to their true value. Because the misvaluation
measure in this study is the ratio of the market price to the true price, firms with a misvaluation value greater than one is overvalued. In
contrast, firms with a misvaluation value less than one are undervalued firms.
In the second step, we estimated the relationship between the valuation effect of ESG and the capital structure. Following Elliott
et al. (2007), we calculated the direct measure of misvaluation. This involves two steps: first, we calculated the firm deficit by using the
following equation:
DEF i,t = DIV i,t + Ii,t + ΔW i,t − Ci,t = ΔDi,t + ΔEi,t (6)

Where DEF is the firm financing deficit, DIVi,t is the cash dividend, Ii,t is the net investment, ΔW i,t is the change in working capital, Ci,t
is the cash flow after interest and taxes, ΔDi,t is the net debt issued during the year t by firm i and ΔEi,t is the equity issued during the
year t by firm i. A positive DEF value indicates a cash surplus, while a negative value indicates a cash deficit. Second, we followed the
Elliott et al. (2007) approach and calculated market timing variable as follows:
Mk Ti,t = DEF i,t ∗ MVi,t (7)

This market timing variable captures what happens when firms are misvalued and in need of financing. According to market timing
theory (Baker & Wurgler, 2002), capital structure is the cumulative result of the attempt of financial management to time the equity
market. If the stock is over-valued then it provides the managers an opportunity to time the equity market and benefits the long term

1
We have replicated the results without the inclusion of the lagged dependent variables in order to address concerns that might arise because of
the inclusion of lagged dependent variables. The results will be provided by authors upon request.

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investors on the cost of entering and exiting ones. If the coefficient of market timing is negative and significant, it shows that when
market is misvalued, then firm time the equity market and issue equity rather than debt. We further regressed the same equation for the
over-valued and undervalued firms separately. We then estimated the following equations:
ΔDi,t = β0 + β1 DEF i,t + β2 Mk Ti,t + ϵi,t (8)

ΔDi,t = β0 + β1 DEF i,t + β2 MkT i,t + β3 LESGi,t + β4 LESGi,t ∗ MkT i,t

β5 Xi,t + ϵi,t (9)

Where ΔDi,t is change in debt, DEFi,t is firm deficit, and LESGi,t ∗ MkT i,t is the interaction term of ESG and market timing, and Xi,t is the
vector of control variable. According to Shayam-Sunder & C. Mayers (1999), if β1 = 1, then there is a one-to-one relationship between
deficit and change in debt and it supports the pecking order theory of capital structure suggested by Myers (1984) and Myers and
Majluf (1984). They found a value of 0.75 and interpreted it as strong evidence for the pecking order theory, whereas Frank and Goyal
(2004) estimated the same model by using net equity issue as a dependent variable and found a coefficient of 0.20. They interpreted
this value as strong evidence for the pecking-order theory.
We do not aim to test the theories of capital structure but to analyze whether financial management time the equity market, so we
are expecting a negative coefficient for the interaction term. In equation (9), the negative coeffects of the interaction term will
illustrate that if the equity prices are overpriced and the firm needs funding, then the firm will issue equity and reduce debt in their
capital structure.

4. Results and discussion

4.1. Descriptive statistics

Table 2 presents the results of summary statistics of the sample. In Panel A, the mean value of " MV RES
i,t " indicates that the market
value exceeds the fundamental value and on average stock is overvalued, but when we examine the mean value of " MV TP i,t ", the market
price is lower than the analysts’ forecasted price, which reveals that analysts over-reacted to ESG metrics and on average stocks are
undervalued relative to fair price forecasted by analysts. In panel B, we have depended variables for the capital structure that shows
how much debt and equity is issued or retired during the sample period. Both variables are scaled by total assets and indicate that, on
average, debt issuance is approximately .044% of total assets, while stock issuance is approximately .09%. This means that European
firms issued more debt than stock during the sample period.
Panel C represents the average values of the explanatory variable that is ESG performance. We used ESG score as main independent
variable whereas we additionally replicated the analysis for each component of ESG for are robustness check to disaggregated analysis.
The values of ESG scores and pillar score are around 50 that shows on average European firms exhibited satisfactory ESG performance.
Panel D lists the control variables: firms in our samples have on average an earnings per share of.045, leverage is 61% of total asset,
capital expenditure is 4.3 percent of total asset and dividend payout ratio is 0.94. Whereas PTBR, market-to-book ratio, signals that
market prices are 3.6 times higher than the book value of equity. Lastly, panel E delineates information asymmetry and market
sentiment variables. The bid-ask spread value is.0058 percent and the average search trend for sustainability topics is 39. As this
number is relative to all searches in EU, so it shows that Sustainability is approximately half popular in EU market.
All variables are summarized in Table 2. Panel A contains the list of dependent variables containing MVRES and MVTP, which serve
as misevaluation proxy measures that are determined by a ratio of market price to intrinsic value calculated by the residual income
model and price target calculated by analysts. There is also a second list of dependent variables for capital structure impacts resulting
from ESG performance, namely (1)D and (1)E, which refer to changes in debt and equity. While in Panel B, ESG score refers to
corporate social responsibility, while E, S, and G refer to environmental, social, and governance scores. Panel C contains the list of
control variables. NA is the number of analysts following the company, PTBR is Price to book ratio, LTA is the log of total asset, LEV is
the leverage, Prof is the profitability, CE is capital expenditure and DPR is the dividend payout ratio. Panel D includes moderating
variables containing bid-ask spread which represents information asymmetry and sustainability is the keyword used to extract the data
of market sentiments from google trends.

4.2. ESG and firm misvaluation

The primary hypothesis of this study is that we expect that ESG performances affect firm misvaluation. Table 3 reports the results of
the direct impact of firm’s ESG activities on the respective firm’s valuation. Based on the adoptive market hypothesis,2 we used lagged
value of ESG score as market participants needs some time to establish a link between ESG performance and financial performance
(Usman et al., 2020). Results have been categorized into three models: model I reports the results for the entire sample. Since mis­
valuation is constructed by comparing market price to fair value, where a value of more than 1 indicates overvalued firms and a value
of less than 1 indicates undervalued firms, the overall effect cannot be generalized across both overvalued and undervalued firms. ESG

2
According to Adoptive hypothesis, markets gets more efficient as market participant gets more information and learn how to interpret it.

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M.A. Khan et al. International Review of Economics and Finance 91 (2024) 19–35

Table 2
Dascriptive statistics.
Variable Obs Mean Std.dev Min Max

Panel A: Dependent Variable Misvaluation Measure MVRes 10,526 2.0950 2.5828 − 1.269 9
MVPtm 9638 0.8422 0.2497 0.204 1
Panel B: Dependent Variable Capital Structure Capital Structure
ΔD 10,331 0.0045 0.0724 − 1.131 1.0161
ΔE 10,331 0.0009 0.0787 − 1.783 1.1297
Corporate Social Responsibility Variables
Panel: Independent variables ESG 9806 49.7092 21.240 0.472 94.519
ESCORE 9804 48.5149 28.328 0.000 98.931
SScore 9804 51.6008 24.204 0.121 98.628
GScore 9804 48.9265 23.218 0.572 99.246
Market Timing Variables
DEF 10,331 0.0054 0.1008 − 1.8071 1.1297
Mk_T 9510 − 0.0008 0.0290 − 1.0000 0.0000
Panel D: Control Variables
NA 10,140 0.2111 0.9380 0.000 14.00
PTBR 8838 3.5822 16.904 0.001 895.23
lTA 10,331 22.5976 1.9392 13.163 28.92
Lev 10,331 0.6142 0.2605 − 0.643 3.95
Prof. 10,331 0.0459 0.1644 − 8.236 2.51
CE 10,331 0.0434 0.0470 0.000 0.78
DPR 9121 0.9413 10.614 0.000 843.92
Panel E: Moderating Variables
Bidask_Sprd 10,386 0.0058 0.0510 − 2.0000 1.3299
Sustainability 10,716 38.8180 11.931 6.0000 77.583

performance can have a positive impact on misvaluation by both augmenting over-valuations for overvalued firms as well as
decreasing under-valuations for undervalued firms. Therefore, we estimated the primary model separately for overvalued and
undervalued firms, and the results are reported in models II and III. We can see that misvaluation based on the residual income model
has a significant and positive association with the lagged value of ESG. This affect remains consistent for overvalued and undervalued
firms in models II and III, respectively. The results indicate that an increase in the ESG score by one unit will increase the misvaluation
by 0.0138 for the entire sample, 0.0171 for overvalued firms, and 0.0119 for undervalued firms. Alternatively, if the true value is
maintained at $10 billion dollars, the market value will increase by $138 million for the overall sample, $171 million for overvalued
firms and $119 million for undervalued firms. For the overvalued firms, the magnitude of the impact is greater, which can be attributed
to their higher legitimacy.
In Table 3, Panel B presents the results of regression between ESG performance and a firm’s misvaluation measured by the analyst
target price. For the entire sample and for undervalued companies, the coefficient is significant and positive, however, it is not sig­
nificant for overvalued companies. Similarly, if the true value is kept constant at $10 billion, one unit increase in ESG performance
increases the market price by 19 million for the entire sample and 16 million for undervalued firms. Besides the fact that the MVTP has a
lower mean value, the smaller magnitude effect compared to the MVRES measure can be attributed to the following factors: Despite the
fact that both ratios represent the same market value, their underlying value is captured through a distinct temporal lens. The residual
income model is a forward-looking approach to estimating true prices but does not anticipate future risks and growth opportunities.
Thus, the fundamental value obtained from this model is understated, and that is the reason we observed greater average misvaluation
values and higher coefficients of misvaluation. On the other hand, true prices forecasted by analysts incorporate all the expected risk
and growth opportunities and also ESG reporting improves the information environment, which helps for a more accurate guess of the
true price of a company stock and that is why average value of misvaluation estimated through price target is closer to one.
In summary, we accept our hypothesis that ESG performance moves market prices above their true values. This gives financial
management the opportunity to time equity markets if they need financing for their positive NPV projects. Moreover, CSR investments
further increase the market prices of already overvalued stocks relative to their fair values, and they also encourage undervalued stocks
to reach their fair value. Our results are in consistent with (Bofinger et al., 2022) that says the higher ESG scores provide a competitive
advantage to the firms as investor think this compliance as a value driver irrespective of its current level of misvaluation.

4.3. Moderating effect of information asymmetry between ESG-misvaluation nexus

We provide evidence in section 4.2 supporting our hypothesis H1, H2 and H3 that sustainability performance is positively related to
misvaluation. We emphasize ESG performance as a key value driver. Previous research has shown that information asymmetry in the
valuation process complements the valuation effect of ESG performance. In part, the information gap between insiders and outsiders
can be attributed to impression management practices and the fallacy of transpiracy in ESG disclosures. It can further complicate the
information environment of the firm and exacerbate misvaluation. We therefore hypothesize that information asymmetry moderates
the relationship between ESG performances and misvaluation.
To assess the moderating effect of information asymmetry in the ESG and the misvaluation nexus, we used bid-ask spread as a proxy
for information asymmetry and introduced an interaction term between bid-ask spread and lagged ESG score. This interaction term

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quantifies the effect of ESG, which is primarily related to the effects of information asymmetry. Furthermore, we examine the potential
effects on overvalued and undervalued companies separately in Models II and III of Table 3. Asymmetry of information could have
opposing effects on these relationships. A decrease in information asymmetry could, therefore, positively impact undervalued firms’
misvaluation and negatively impact overvalued ones.
Table 4 provides the results of the regression with the information asymmetry variable included as a moderator. Panel A reports the
results of the MVRES misvaluation calculated based on the residual income model, and panel B presents the results of the MVTP mis­
valuation based on the analyst target prices. While models I, II, and III report the results for the entire sample, the overvalued com­
panies, and the undervalued companies, respectively.
We find that the interaction between ESG and bid ask spread has a significant effect on the entire sample and the undervalued firms.
However, the interaction is not significant for over-valued firms. In addition to this, the individual impact of bid ask spread is also
significant, which confirms the importance of information asymmetry as a moderator between ESGs and misvaluation.
The coefficient of interaction between sustainability and the lag value of ESG is greater than each ESG coefficient individually.
Additionally, the average value of MVTP in Table 1 is less than one, which indicates that analysts’ target prices are on average greater
than current market prices. In contrast, a value greater than 2 of MVRES indicates that market prices are almost two times the
fundamental value, and investor also appreciates ESG performance.
If we read these findings in connection, it illustrates that ESG performances affect the information environment of the company and
make the investor and analysts’ opinions more optimistic about the future prospects of the company. Moreover, analysts, who act as an
information intermediary, assign a higher expected future price, which also deepens the valuation effect of ESG and increases the gap
between fundamental value market prices.
In summary, ESG performance leads to higher information asymmetry as investors and analysts adopt a more optimistic viewpoint.
However, this effect is only significant for firms that are undervalued and for the entire sample.

Table 3
Regression analysis.
Variables Panel A MVRES Panel B MVTP

Model 1 Model 2 Model 3 Model 1 Model 2 Model 3

Lag-Misevaluation 0.1453*** 0.1838*** 0.1374*** 0.0239** − 0.007 0.0958***

(0.0126) (0.0321) (0.0139) − 0.0112 − 0.0196 − 0.0084
LESG 0.0143*** 0.0171*** 0.0119*** 0.0019*** 0.0001 0.0016***
(0.0024) (0.0067) (0.0026) − 0.0003 − 0.0007 − 0.0002
Prof. 4.9628*** 3.5830*** 5.9504*** − 0.1442 − 0.264 − 0.0833
(0.5511) (1.1188) (0.6701) − 0.06727 0.1552 0.0459
Lev 2.2540*** 1.9050*** 2.2942*** 0.0912** 0.3346*** − 0.0880**
(0.3348) (0.8049) (0.3864) − 0.04297 − 0.0964 − 0.0294
lTA − 0.2507*** 0.2134 − 0.1038 − 0.1469*** − 0.1193*** − 0.0447***
(0.0865) (0.2247) (0.1029) − 0.0115 − 0.0264 − 0.0079
CEA 1.2688 1.3114 0.782 − 0.5117*** 0.0814 − 0.3249***
(1.0004) (2.6740) (1.094) − 0.1245 − 0.2893 − 0.0833
DPR 0.00 0.0005 0.0030 0.00 0.0004 0.0002
(0.0019) (0.0270) (0.0019) − 0.0002 − 0.0029 − 0.0001
NA − 0.0029 − 0.0555 0.0095 − 0.0129*** 0.004 − 0.0101***
(0.0218) (0.0926) (0.0219) − 0.00266 − 0.0095 − 0.0017
PTBR − 0.0054*** 0.0144** − 0.0097*** 0.0002*** 0.0001 0.0001
(0.0021) (0.0071) (0.0022) − 0.00025 − 0.0007 − 0.0002
_cons 5.4371 − 4.2248 1.9105 4.1111*** 3.6518*** 1.7421***
1.9696 (4.9573) (2.3636) − 0.2633 − 0.5874 − 0.1818
R-squared:
Within 0.05 0.06 0.058 0.0423 0.0396 0.0723
Between 0.45 0.10 0.440 0.0028 0.0618 0.0000
Overall, 0.31 0.11 0.275 0.009 0.0399 0.005
Number of obs 6394 1535 4859 6272 1438 4834
Prob>F 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

A regression analysis of the impact of corporate social responsibility on firm misvaluation is presented in Table 2 using a fixed affect model with a
lagged dependent variable. The results are presented in two panels. Panel A shows the results for MVRES as a dependent variable. This is calculated by
the ratio of market price to intrinsic value whereas intrinsic value is calculated through the residual income model. Panel B represents the results for
MVTP where intrinsic value is proxied by the price target forecasted by analysts’. Whereas Model I contains the regression results for the overall
sample size and models II and III contain the regression results for overvalued and undervalued stocks respectively. Whereas Lag-Misvaluation is
lagged value of dependent variable, LESG is lagged value of ESG score, Prof. is profitability, LEV is the Leverage, lTA is the log of total asset, CEA is the
capital expenditure, DPR is the dividend payout ratio, NA is the analysts’ coverage and PTBR is the price to book ratio.
The data for all the variable is extracted from Refinitiv database for the period of 2008–2019.
The values in brackets are the standard error of regression.
***, **, and * represent 99%, 95% and 90% significance levels, respectively.

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M.A. Khan et al. International Review of Economics and Finance 91 (2024) 19–35

Table 4
Regression analysis-information asymmetry.
Variables Panel A: MVRES Panel B: MVTP

Model I Model II Model III Model I Model II Model III

lMPRes_w 0.1438*** 0.1803*** 0.134*** 0.0156 − 0.0172 0.08918***

(0.01) (0.03) (0.01) (0.0112) (0.0185) (0.0084)
LESG 0.0138*** 0.017** 0.012*** 0.0018*** − 0.0005 0.0015***
(0.0024) (0.01) (0.00) (-0.0003) (0.0007) (0.0002)
bidasks − 7.607*** 1.405 (9.325777*** 0.1249 1.8908*** 1.1418***
(2.98) (6.69) (3.53) (0.3665) (0.6711) (0.2657)
Bidasks*lesg 0.2858*** 0.0146 0.3217*** 0.0343*** − 0.0059 0.0277***
(0.12) (0.27) (0.13) (0.0144) (0.0270) 0.0099
Prof. 4.9935*** 3.557*** 6.0239*** 0.1503** − 0.3468*** − 0.0821*
(0.55) (1.12) (0.67) (0.0669) (0.1470) (0.0458)
Lev 2.343*** 1.802** 2.3672*** 0.0743* 0.1845** − 0.0757***
(0.34) (0.81) (0.39) (0.0429) 0.0926 (0.0293)
lTA − 0.276*** 0.264 − 0.1271 − 0.1465*** − 0.0566** (0.0514169***
(0.09) (0.23) (0.10) 0.0115 (0.0257) (0.0079)
CEA 1.247 1.278 0.7090 − 0.5038*** 0.0461 − 0.3462***
(1.00) (2.68) (1.10) (0.1236) (0.2737) (0.0828)
DPR 0.0013 0.000 0.0031 0.0000 − 0.0002 0.0002
(0.0019) (0.027) (0.0020) (0.0002) (0.0028) (0.0001)
NA − 0.0010 − 0.056 0.0111 − 0.0126*** 0.0021 − 0.0097***
(0.022) (0.093) (0.022) 0.0026 (0.0089) (0.0017)
PTBR − 0.0054** 0.014** − 0.0098*** 0.0002 − 0.0001 0.0001
(0.002) (0.007) (0.002) (0.0002) (0.0007) (0.0002)
_cons 6.0272*** − 5.277 2.466 4.1247*** 2.373201*** 1.905***
(1.985) (5.068) (2.378) (0.2632) (0.5687) (0.1815)
R-squared:
Within 0.05 0.07 0.060 0.05 0.14 0.075
Between 0.45 0.08 0.441 0.00 0.10 0.000
Overall, 0.31 0.09 0.278 0.01 0.14 0.003
Number of obs 6382 1535 4847 6260 1438 4822
Prob>F 0.00 0.00 0.00 0.00 0.00 0.00

In Table 3, the regression results are presented for the impact of corporate social responsibility performance on firm misvaluation with the infor­
mation asymmetry variable as the moderating variable. To estimate these findings, we used a fixed affect model with a lagged dependent variable.
The results are presented in two panels. Panel A shows the results for MVRES as a dependent variable. This is calculated by the ratio of market price to
intrinsic value whereas intrinsic value is calculated through the residual income model. Panel B represents the results for MVTP where intrinsic value is
proxied by the price target forecasted by analysts. Whereas Model I contain the regression results for the overall sample size and models II and III
contain the regression results for overvalued and undervalued stocks respectively. Whereas Lag-Misvaluation is lagged value of dependent variable,
bidasks is the bid ask spread and the interaction term of LESG and bid-ask spread estimate the combine affect of LESG and bid ask spread. Whereas
LESG is lagged value of ESG score, Prof. is profitability, LEV is the Leverage, lTA is the log of total asset, CEA is the capital expenditure, DPR is the
dividend payout ratio, NA is the analysts’ coverage and PTBR is the price to book ratio.
The data for all the variable is extracted from Refinitiv database for the period of 2008–2019.
The values in brackets are the standard error of regression.
***, **, and * represent 99%, 95% and 90% significance levels, respectively.

4.4. Market sentiment and ESG-misvaluation nexus

ESG criteria have become increasingly relevant to corporate business models in recent years. Additionally, investors are becoming
more aware of sustainable investment and expanding their investment horizons. Our findings in section 4.2 that attribute a positive
association between ESG and misvaluation may have been influenced by the increased interest in corporate sustainability. As a result,
we propose hypothesis 5 that market sentiments towards sustainability moderate the relationship between ESG and misvaluation. The
more positive the market sentiment, the wider the deviation from the true price will be. A number of studies have previously
investigated the role of sentiments in corporate finance (Baker & Wurgler, 2002; Elliott et al., 2007).
In order to emphasize the role of social awareness in the transition to a sustainable economy, we included a market sentiment
variable. Google trend data on ’sustainability’ is used as a proxy for market sentiment. In order to determine whether market senti­
ments act as a moderating factor for sustainability and misvaluation, we use the interaction term between sustainability and the ESG
lag value. Table 5 provides the results of the regression analysis of market sentiments. For all regression models, the interaction term
between sustainability and lagged ESG is positive. This acclaim that a higher sentiment toward sustainability will increase the mis­
valuation ratios incented by ESG. We can conclude that ESG and misvaluation are moderated by the general sentiment towards
sustainability. Consequently, these results support Hypothesis 5’s argument that sustainability topics moderate the relationship be­
tween ESG and misvaluation.

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4.5. ESG and capital structure

In this section, we estimated the impact of ESG-triggered misvaluation on the financial mix of the companies. Previously, we
showed that ESG performance boosts stock overvaluation and helps undervalued stocks return to their fair value. Table 6 reports the
results of the model specified in Eqs. (8) and (9). In panel A, we used change in debt as a dependent variable, whereas in panel B we
replicated the same model for the change in equity as a dependent variable for robustness. We can see that in Panel (A) and model 1,
the coefficient of the deficit is 0.69 implying that 69 percent of the deficit is financed by the debt issuance whereas in panel B model (3)
the coefficient is 0.3056 which shows that around 31 % of the deficit is financed by issuing equity. These findings are in line with
Shyam-Sunder and C.Myers (1999), who found the coefficient of deficit equal to 0.75 and reported it as strong evidence for pecking
order theory, while Frank and Goyal (2003) found the deficit coefficient equal to 0.20 and also argued that it is strong evidence against
the pecking order theory. The second variable in Table 6 is an interaction term of financing deficit and misevaluation measure (where
MP > 1 for overvalued firms and MP < 1 for undervalued firms). The coefficient of market timing variable is negative for model (1) and
(2) indicating that as firm becomes more overvalued the market timing variable coefficient becomes lower and firm issue more equity
than debt. Model (3) and (4) replicate the analysis with change in equity as dependent variable and we can see that coefficient of the
market timing variable (interaction of deficit and misevaluation) is positive here, indicating that when the firms become overvalued,
the coefficient of market timing becomes higher. In other words, overvalued firms issue more equity to finance their deficit.
In Table 6, the coefficient of interaction term of market timing and ESG is negative for models (1) and (2), indicating that higher
ESG performance increases the overvaluation of stocks, and this overvaluation of the stock reduces the level of debt in capital structure.

Table 5
Market sentiments.
Panel A: Dependent Variable MVRES Panel B: Dependent Variable MVTP Model II

Model I Model II Model II Model I Model II

lMPRes_w 0.1476*** 0.1788*** 0.0015 0.0299*** − 0.0064 0.1038***

(0.0125) (0.032) (0.0010) 0.0111 (0.0196) (0.0082)
LESG − 0.0066 − 0.0076 − 0.0099 − 0.0002 0.0018 − 0.00096**
(0.0056) (0.0179) (0.0061) 0.0007 (0.0019) (0.0004)
Sustainability − 0.05054*** − 0.057*** − 0.050*** − 0.0071*** 0.0020 − 0.0070***
(0.0075) (0.021) (0.0083) (0.0009) (0.0023) (0.0006)
S*ESG 0.0005*** 0.0005 0.0006*** 0.00004*** 0.0000 0.0000576***
(0.0001) (0.0004) (0.0001) (0.0000) (0.0000) (0.0000)
Prof. 4.9840*** 3.582*** 6.844*** − 0.1435** − 0.2667* − 0.0892**
(0.5478) (1.114) (0.669) (0.0665) (0.1553) (0.0446)
Lev 2.4493*** 2.003*** 2.647*** 0.1297*** 0.3408*** − 0.054**
(0.3334) (0.805) (0.3892) (0.0426) (0.0970) (0.0286)
lTA − 0.331*** 0.0413 − 0.1070 − 0.1583*** − 0.1169*** − 0.0529***
(0.0865) (0.230) (0.1038) (0.0114) (0.0270) (0.0077)
CEA 1.3061 0.9663 1.3457 − 0.4770*** 0.1014 − 0.2980***
(0.995) (2.668) (1.1015) (0.1233) (0.2902) (0.0810)
DPR 0.0015 0.0004 0.0027 0.0000 0.0004 0.0002
(0.0019) (0.027) (0.0020) (0.0002) (0.0029) (0.0001)
NA 0.0355 − 0.00066 0.0389* − 0.0042 0.0048 − 0.0037**
(0.0229) (0.0958) (0.0235) (0.0028) (0.0099) (0.0017)
PTBR − 0.0059*** 0.0137** − 0.0111*** 0.0001 0.0001 0.0000
(0.0022) (0.0071) (0.0022) (0.0002) (0.0007) (0.0002)
_cons 9.1512*** 1.845 3.8879 4.630478*** 3.516213*** 2.1853***
(2.008) (5.29) (2.4179) (0.2656) (0.6209) (0.1795)
R-squared:
Within 0.07 0.0739 0.05 0.0677 0.0406 0.1292
Between 0.38 0.1707 0.09 0.0023 0.0621 0.003
Overall 0.27 0.1609 0.06 0.0103 0.0399 0.0029
Number of obs 6379 1534 4845 6257 1437 4820
Prob>F 0.00 0.00 0.00 0.00 0.00 0.00

In Table 4, the regression results are presented for the impact of corporate social responsibility performance on firm misvaluation with the market
sentiments variable as the moderating variable. To estimate these findings, we used a fixed affect model with a lagged dependent variable. The results
are presented in two panels. Panel A shows the results for MVRES as a dependent variable. This is calculated by the ratio of market price to intrinsic
value whereas intrinsic value is calculated through the residual income model. Panel B represents the results for MVTP where intrinsic value is proxied
by the price target forecasted by analysts. Whereas Model I contain the regression results for the overall sample size and models II and III contain the
regression results for overvalued and undervalued stocks respectively. Whereas Lag-Misvaluation is lagged value of dependent variable Sustainability
is the is the keyword trend showing the market sentiments about sustainability and the interaction term of S*LESG estimate the combine effect of
LESG and market sentiments about sustainability. Whereas LESG is lagged value of ESG score, Prof. is profitability, LEV is the Leverage, lTA is the log
of total asset, CEA is the capital expenditure, DPR is the dividend payout ratio, NA is the analysts’ coverage and PTBR is the price to book ratio.
The data for all the variable is extracted from Refinitiv database for the period of 2008–2019 whereas the data for market sentiments is extracted from
google trends search volume.
The values in brackets are the standard error of regression.
***, **, and * represent 99%, 95% and 90% significance levels, respectively.

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M.A. Khan et al. International Review of Economics and Finance 91 (2024) 19–35

Table 6
ESG and capital structure.
Variable Panel A: Change in Debt Panel B: Change in Stock

(1) (2) (3) (4)

DEFA 0.6944*** 0.7623*** 0.3056*** 0.2377***

(0.0062) (0.0070) (0.0062) (0.0070)
Mkt − 0.6346*** − 18.58*** 0.6346** 18.58***
(0.0234) (2.9365) (0.0234) (2.9365)
LESG − 0.0001* 0.0001*
(0.0000) (0.0000)
Mkt*LESG − 0.0066** 0.0066**
(0.0029) (0.0029)
Prof. − 0.0007 0.0007
(0.0077) (0.0077)
Mkt* Prof − 0.3993*** 0.3993***
(0.0812) (0.0812)
lTA 0.0081*** − 0.0081***
(0.0016) (0.0016)
Mkt*lTA 0.8676*** − 0.8676***
(0.1362) (0.1362)
CEA 0.0898*** − 0.0898***
(0.0188) (0.0188)
Mkt* CEA − 8.2364*** 8.2364***
(2.8156) (2.8156)
DPR 0.0000 0.0000
(0.0000) (0.0000)
Mkt* DPR 9.4518 − 9.4518
(1.3559) (1.3559)
_cons 0.0013*** − 0.1824*** − 0.0013*** 0.1824***
(0.0005) (0.0364) (0.0005) (0.0364)
R-squared:
Within 0.5918 0.6733 0.3295 0.3728
Between 0.2654 0.3590 0.7568 0.6466
Overall 0.5061 0.5306 0.5449 0.5680
Number of Observations 9510 7313 9510 7313
Prob of F 0.0000 0.0000 0.0000 0.0000

Table 5 illustrates the results of regression analysis of misevaluation induced by sustainability performance on the capital structure. Panel A presents
the results with change in debt as a dependent variable. Model I illustrates the regression findings of capital structure and misvaluation and model II
presents the regression results with the inclusion of the control variable. In panel B we used change in equity as a dependent variable.
Data for all variables is taken from the Refinitiv database for the period 2008 to 2019.
The values in brackets are the standard error of regression.
***, **, and * represent 99%, 95% and 90% significance levels, respectively.

On the other hand, we can see that the coefficient of interaction term of ESG and market timing in models (3) and (4) is positive,
indicating when the ESG performance increases it makes stock overvalued and firm issue equity to finance their deficit to time the
equity market and benefits the long run shareholders on the cost of investors with short run investment horizon.
In summary, our findings support the studies (Shyam-Sunder & C.Myers, 1999; Frank & Goyal, 2003) that European firms follow
the pecking order theory of capital structure while designing their financial mix. Second, financial management also time the equity
market when stocks are overvalued in order to exploit the equity market and benefits the long-term shareholder at the cost of entering
and exiting. These findings provide support to the findings of (Baker & Wurgler, 2002; Elliott et al., 2007).
Thirdly, ESG performance create an opportunity to time the equity market by boosting the stock overvaluation phenomenon and
financial management time this opportunity by issuing equity to finance their financing deficit.

4.6. Additional analysis

4.6.1. Endogeneity issue

Previous analysis shows a strong link between ESG performance and misvaluation. However, an endogeneity bias could lead to
incorrect conclusions. Previous literature extensively reported that the ESG-misvaluation relationship raises the possibility of problems
of simultaneity and reverse causality. We addressed the simultaneity issue by including the lag value of ESG as it takes time to translate
ESG performance into value implication. Whereas, we included the lag dependent variable to eliminate the reverse causality concern.
This is because it reduces the possibility of reverse causality bias, which is a typical issue in CSR regression analysis. Another issue that
needs to be addressed is the omission of variables. This occurs when factors that are not readily evident influence the explanatory and/
or dependent variables. We further repeated the main analysis by using 2SLS model. At first stage, we regreased ESG against profit­
ability and at the second stage we used fitted values of lag ESG against misevaluation.
In summary, 2SLS estimations where ESG is instrumented by profitability rule out endogeneity concerns do not contradict but

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rather corroborate our findings. Therefore, we can confirm the existence of a significant association between ESG and misvaluation.

4.6.2. Pillar score analysis

The results of our study indicate a positive association between a company’s ESG performance and its mispricing. ESG is a com­
posite score that incorporates three pillars: environmental, social, and governance. Multiple studies analyzing these pillars individually
conclude that a single pillar is mostly responsible for their relationship. For example, the environmental pillar score is relevant for
sensitive industries (Garcia et al., 2017; Miralles-Quirós et al., 2018), whereas (Luffarelli & Awaysheh, 2018) provide evidence that
corporate social performance is also an important value driver. Therefore we re-examine our main analysis of section 4.2 by using each
of the pillar score as explanatory variable. In Table 8 models 1 to 3 are for misevaluation measured through analysts forecasted price,
whereas models 4 to 6 are for misevaluation calculated by residual income model. We can see in Table 8 that only environmental pillar
score has significant coefficients for the entire sample and undervalued firms. The social and governance pillar score is statistically
insignificant. This finding indicates that environment performance is the key value driver for the European firms.

5. Conclusion

Since the demand for corporate environmental, social and governance (ESG) reporting has grown exponentially over the past few
decades, businesses have adapted sustainable and socially responsible practices and reported them as a means of maintaining their
competitiveness. The dominance of ESG investments in the financial market has contributed to the inefficiency of the inefficiency of
the inefficiency of the inefficiency of the inefficiency of the inefficiency of the inefficiency of the stock market (Becchett et al., 2012).
Due to this market inefficiency, superior ESG performance affect can increase the stock process relative to their intrinsic value. This
study aims to examine whether CSR affects the gap between intrinsic and market value of firms in Europe. Our study demonstrates that
a firm’s involvement in ESG influences its misvaluation by increasing its market value relative to its intrinsic value. We estimated the
link between ESG and stock misevaluation by using pooled fixed effect model with lag-dependent variable and replicated the main
analysis by using 2SLS where we instrumented ESG performance by profitability and at second stage we regressed as a measure the
robustness to estimation. We also used two different measure of misevaluation: one is calculated by using intrinsic value measured
residual income model and the second misevaluation measure used analysts estimated true price in order to take into account the
growth opportunities and unanticipated potential risk. Our main findings are robust to estimation technique and also to the measure of
estimation. Further disaggregated analysis revealed the environmental performance is the most relevant determinant of stock value
appreciation.
Second, we also conducted the analysis for overvalued and undervalued stocks separately. We find that ESG performance further

Table 7
2SLS regression analysis to address potential endogeneity concerns.
Panel A: Dependent variable MVTP Panel B: Dependent variable MVRE.S.
VARIABLES Model I Model II Model III Model I Model II Model III

LESG 0.00190*** 0.000171 0.00157*** 0.0132*** 0.0164** 0.0106***

(0.000303) (0.000710) (0.000206) (0.00244) (0.00680) (0.00267)
Lev 0.107** 0.366*** − 0.0788*** 1.699*** 1.503* 1.700***
(0.0423) (0.0948) (0.0290) (0.331) (0.793) (0.384)
lTA − 0.145*** − 0.114*** − 0.0438*** − 0.342*** 0.0557 − 0.155
(0.0115) (0.0263) (0.00790) (0.0866) (0.222) (0.104)
CEA − 0.543*** 0.0101 − 0.343*** 2.186** 2.218 1.850*
(0.124) (0.287) (0.0828) (1.002) (2.661) (1.099)
DPR 6.91e-06 0.00109 0.000207 0.00116 − 0.0119 0.00297
(0.000237) (0.00291) (0.000150) (0.00196) (0.0268) (0.00200)
NA − 0.0130*** 0.00401 − 0.0101*** − 0.000137 − 0.0596 0.0128
(0.00266) (0.00949) (0.00167) (0.0219) (0.0927) (0.0222)
PTBR − 9.29e-06 − 0.000104 2.68e-05 − 0.000715 0.0171** − 0.00400*
(0.000232) (0.000717) (0.000147) (0.00209) (0.00708) (0.00214)
LMPResw
Constant 4.061*** 3.507*** 1.716*** 8.144*** − 0.271 3.768
(0.262) (0.582) (0.181) (1.960) (4.856) (2.378)
Observations 6272 1433 4828 6394 1530 4853
Number of ID 737 511 734 738 527 732

A regression analysis of the impact of corporate social responsibility on firm misvaluation is presented in Table 6 using a 2SLS where ESG is
instrumented by profitability at first stage and the fitted values are used at second stage.The results are presented in two panels. Panel A shows the
results for MVRES as a dependent variable. This is calculated by the ratio of market price to intrinsic value whereas intrinsic value is calculated through
the residual income model. Panel B represents the results for MVTP where intrinsic value is proxied by the price target forecasted by analysts’. Whereas
Model I contains the regression results for the overall sample size and models II and III contain the regression results for overvalued and undervalued
stocks respectively. Whereas LESG is lagged value of ESG score, Prof. is profitability, LEV is the Leverage, lTA is the log of total asset, CEA is the capital
expenditure, DPR is the dividend payout ratio, NA is the analysts’ coverage and PTBR is the price to book ratio.
The data for all the variable is extracted from Refinitiv database for the period of 2008–2019.
The values in brackets are the standard error of regression.
***, **, and * represent 99%, 95% and 90% significance levels, respectively.

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M.A. Khan et al. International Review of Economics and Finance 91 (2024) 19–35

Table 8
Pillar score and mis-valuation.
Panel A: MVTP Panel B: MVRES

VARIABLES VARIABLES Model I Model II Model III Model I Model II

LMPPtm 0.0221* − 0.0055 0.0948*** 0.144*** 0.193*** 0.137***
(0.0113) (0.0197) (0.00843) (0.0126) (0.0322) (0.014)
LESCORE 0.00114*** − 0.000935 0.000843*** 0.00388** − 0.0084 0.00365*
(.000257) (0.000583) (0.000175) (0.00208) (0.00556) (0.00229)
LSScore 0.000534* 0.00081 0.000483** 0.00833*** 0.0186*** 0.00610**
(0.000285) (0.00063) (0.000194) (0.00232) (0.00607) (0.00255)
LGScore 0.000108 5.09E-05 0.000189 0.00259 0.00582 0.00267
(0.000212) (0.000468) (0.000144) (0.00172) (0.00446) (0.00199
Prof. − 0.142** − 0.262* − 0.0799* 4.956*** 3.631*** 5.961***
(0.0673) (0.155) (0.0459) (0.551) (1.113) (0.671)
Lev 0.0971** 0.331*** − 0.0838*** 2.271*** 1.951** 2.313***
(0.043) (0.0968) (0.0294) (0.335) (0.802) (0.387)
lTA − 0.148*** − 0.116*** − 0.0451*** − 0.260*** 0.226 − 0.111
(0.0115) (0.0267) (0.0079) (0.0867) (0.225) (0.103)
CEA − 0.505*** 0.0705 − 0.324*** 1.364 1.149 0.811
(0.125) (0.291) (0.0833) (1.002) (2.672) (1.096)
DPR − 2.67E-06 0.000539 0.000204 0.00136 0.00289 0.00307
(0.000236) (0.00294) (0.00015) (0.00194) (0.0269) (0.00198)
NA − 0.0129*** 0.00385 − 0.0100*** − 0.00653 − 0.0579 0.0072
(0.00267) (0.00949) (0.00168) (0.0219) (0.0923) (0.0222)
PTBR 0.000203 3.81E-05 0.000149 − 0.00532** 0.0142** − 0.00969***
(0.000252) (0.000723) (0.000162) (0.00214) (0.00709) (0.00221)
Constant 4.136*** 3.589*** 1.754*** 5.609*** − 4.532 2.033
− 0.264 − 0.592 − 0.182 − 1.971 − 4.958 − 2.366
Observations 6272 1433 4828 6394 1530 4853
R-squared 0.043 0.043 0.074 0.054 0.074 0.059
Number of ID 737 511 734 738 527 732

A regression analysis of the impact of corporate social responsibility on firm misvaluation is presented in Table 7 using a fixed affect model with a
lagged dependent variable. The results are presented in two panels. Panel A shows the results for MVTP as a dependent variable. This is calculated by
the ratio of market price to intrinsic value whereas intrinsic value is calculated through the residual income model. Panel B represents the results for
MVRES where intrinsic value is proxied by the price target forecasted by analysts’. Whereas Model I contains the regression results for the overall
sample size and models II and III contain the regression results for overvalued and undervalued stocks respectively. Whereas Lag-Misvaluation is
lagged value of dependent variable, L-ESCORE is lagged value of Environmental score, L-SSCORE is lagged value of Social score, L-GSCORE is lagged
value of Governance score, Prof. is profitability, LEV is the Leverage, lTA is the log of total asset, CEA is the capital expenditure, DPR is the dividend
payout ratio, NA is the analysts’ coverage and PTBR is the price to book ratio.
The data for all the variable is extracted from Refinitiv database for the period of 2008–2019.
The values in brackets are the standard error of regression.
***, **, and * represent 99%, 95% and 90% significance levels, respectively.

expands the overvaluation and pulls back the already undervalued stock. We further find that information asymmetry and market
sentiment moderate the relationship between the ESG-misevaluation nexus. Therefore, we maintain that superior ESG performance
and its disclosure create friction to market efficiency and lead to valuation effects (Becchett et al., 2012; Mynhardt et al., 2017). This
information asymmetry is attributed to strong sustainability trends channeling ESG-rating-based capital flows (Fatemi et al., 2018;
Renneboog et al., 2008; Starks et al., 2017) This valuation effect, which exceeds the intrinsic value, corroborates the implications of the
stakeholder theory (Freeman, 1984)) which places CSR engagement well beyond shareholder value theory (Friedman, 1970). The
significance of the moderating role also implies that the effect of ESG on mispricing is exacerbated by a greater focus on ESG related
topics. In other words, media and societal attention can change investors’ perspectives on sustainability issues, which ultimately
increases the relevance ESG norms in terms of valuation. It will also help the market to internalize ESG indicators in pricing mech­
anism. Our findings suggest that sustainable investors may behave somewhat irrationally because they attribute relatively higher
values to an enhanced sustainability profile rather than to financial information. Alternatively, sustainable investors may receive
psychic return along with financial returns from their monitory investments (Beal et al., 2005).
Our finding also reveals that ESG performance also affects the capital structure, as overvaluation provides an opportunity to time
the equity market. We find that although European firms follow pecking order theory but ESG induced misvaluation also has marginal
effect on firm capital structure. CSR firms issue equity when their stock is overvalued, and they need financing for their positive NPV
projects. These findings are in line with the (Baker & Wurgler, 2002; Elliott et al., 2007). It can also be contented from our findings that
enhanced stability of CSR can also be attributed to the marginal increment in equity issuance rather than the social legitimacy effect of
ESG itself.
The study has several implications for corporations. Firstly, ESG practices should be strategically embraced and strengthened by
organizations. Proactive engagement with ESG factors not only enhances stock valuation but also positively shapes investor percep­
tion. There is a need for companies to be vigilant when it comes to monitoring potential overvaluation, especially when it is driven by
superior ESG performance. It is imperative to implement robust monitoring mechanisms to identify cases of overvaluation and inform

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M.A. Khan et al. International Review of Economics and Finance 91 (2024) 19–35

strategic decisions, particularly when it comes to financing. Recognizing the link between ESG-backed stock overvaluation and capital
structure decisions, financial managers should strategically time equity issuances in response to ESG-related overvaluation, optimizing
the overall capital structure. Transparent communication of ESG initiatives is crucial for fostering positive investor perceptions and
contributing to sustained stock overvaluation. Lastly, the integration of ESG considerations into financial planning processes provides
a holistic view of the financial landscape, enabling informed decision-making and strategic planning.
The study is subject to certain limitations. Specifically, the analysis was conducted at the aggregate EU level. Future research
endeavors could extend the investigation to encompass individual regional territories, particularly in emerging economies. Further­
more, the replication of the study through a comparative analysis across diverse sectors may offer valuable insights. Investigating the
long-term sustainability of ESG-backed stock overvaluation and its implications for corporate resilience would provide valuable in­
sights. Further research could delve into the dynamics of investor preferences and how they shape the relationship between ESG and
stock valuation. Investigating the long-term sustainability of ESG-backed stock overvaluation and its implications for corporate
resilience would provide valuable insights. Additionally, examining the effectiveness of various communication strategies for ESG
initiatives and their influence on investor behavior could contribute to refining corporate communication practices.

Compliance with ethical standards

We confirm that we have complied with ethical standards.

Declaration of competing interest

We confirm that we do not have any conflict of interest.

Data availability

Data will be made available on request.

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