Equity Spread and Value Creation

Abstract

In order to enhance corporate value via bolstering ROE on a sustained basis, the author proposes certain financial strategies in Chap. 4 through 6 as follows: -How to Unlock the Value in Japan via Three Pillars of Financial Strategies- Chapter 4: Equity Spread and Value Creation Chapter 5: Value Creative Investment Criteria Chapter 6: Optimal Dividend Policy based on Optimal Capital Structure Equity Spread (ES) and Value Creation: ROE 8% is Japan’s magic number. Chapter 3 showed that improving ROE is necessary to maximize corporate value, but why did the Ito Review specify a minimum 8% ROE when Japanese managers find 2 or 3% sufficient? This Chapter explains that 8% was chosen as a numerical target to raise Japanese managers’ awareness of ROE as the first financial strategy. Using market data and survey results it verifies the adequacy of that standard and proposes the first of three strategies grounded in the premise that ROE must exceed Cost of Equity (CoE) to create corporate value as mathematically proven by the Residual Income Model (RIM). Japanese managers sometimes naively find ROE 2 or 3% sufficient because they traditionally believe operating in the black under GAAP is an absolute priority without considering CoE, mainly due to “bank-governance” described in Chap. 1. However, being in the black in financial accounting does not always create corporate value; being in the black in terms of managerial accounting does. Corporate value emerges in the Equity Spread (ES) between ROE and (CoE). That is, ES (%) = ROE − CoE. The book’s survey results (2013, 2014, 2015) show that approximately 90% of global investors accept 8% as CoE or their opportunity cost. That’s because 8% is an expected Cost of Equity and ROE must exceed CoE to create a positive Equity Spread as a proxy for value creation. Hence, ROE 8% or above required by the Ito Review should be theoretically and practically acceptable. That percentage is endorsed by empirical research: comparing ES and stock performance confirms that investors also focus on the correlation. In addition, long-term market data prove that positive ES is mandatory to create PBR (Price Book-value Ratio) exceeding one and its break-even-point stands at the ROE 8% level. Accordingly, this chapter advocates a positive ES as a strategy to raise consciousness of value creation among corporate managers in Japan.