Key points

  • ROE is compared with cost of equity and ROIC is compared with WACC. If you use the wrong indicators for comparison, your judgment on value creation will also be wrong.
  • There is no one-size-fits-all correct answer to the cost of capital. It is important to be able to explain calculation methods, assumptions, reference periods, and sensitivities.
  • PBR and stock prices are the resulting market evaluations, and what management should directly control are profitability, growth, invested capital, risk, and capital allocation.

Why terminology matters

The expressions “increase capital efficiency” and “be conscious of the cost of capital” alone do not have a clear practical meaning. The numbers used and decisions made will differ depending on whether you are looking at shareholder returns for the company as a whole, the return on invested capital for each business, or the cost of capital including debt.

What TSE is seeking is not to increase the number of difficult financial terms. It means accurately understanding your company's cost of capital and return on capital, and using it to make decisions about investments, withdrawals, M&A, shareholder returns, and business portfolios. In IR materials, it is necessary to indicate terms and formulas, and then explain the connection to management decisions.

List of basic terms

term general formula what to measure Main comparison target
Cost of equity In CAPM rE = rf + β × ERP Required rate of return commensurate with the risk borne by shareholders ROE, shareholder return, stock value evaluation
Cost of Debt effective interest rate. WACC usually adjusts after tax Financing costs such as loans and bonds Investment decisions, capital structure
WACC (E/V)×rE + (D/V)×rD×(1−tax rate) Weighted average cost of capital including equity and interest-bearing debt ROIC, business investment, corporate value evaluation
ROE Net income ÷ average equity capital How much final profit was generated relative to shareholders' equity? cost of equity
ROIC NOPAT ÷ invested capital How much operating profit after tax was generated from the capital invested in the business? WACC
Equity Spread ROE - Cost of stockholders' equity Excess return on equity Is it greater than 0?
ROIC spread ROIC－WACC excess return on invested capital Is it greater than 0?
Residual profit/economic profit (ROE−rE) x equity capital or (ROIC−WACC) x invested capital Capture excess returns in terms of amounts rather than rates Value creation amount by business/period
CROIC Depends on company definition Return on invested capital using cash flow WACC etc.
PBR decomposition PBR = ROE × PER Dividing PBR into current profitability and market valuation Comparison with peers, cause analysis

Cost of equity and WACC

The cost of equity is the expected rate of return for the business and financial risks borne by shareholders. CAPM is often used in practice.

Cost of Equity Capital (CAPM)

rE = risk-free rate + β × stock risk premium

The results will vary depending on which government bond yield you use, how many years and how often you estimate beta, and how you set the stock risk premium. Therefore, just because a company presents one number does not necessarily mean that investors will adopt the same premise. It is more practical to show the basis of numerical values, ranges, and sensitivities.

WACC is a weighted average of the cost of equity and the cost of debt based on the composition ratio of equity and interest-bearing debt. The after-tax cost of debt is used because interest paid has a tax effect.

WACC

WACC = (E/V)×rE + (D/V)×rD×(1−t)

Here, E is stock value, D is interest-bearing debt, V is E+D, and t is the effective tax rate. Definitions vary from company to company, including whether market value or book value is used, and how cash is deducted from invested capital. In disclosure, it is necessary to specify not only the calculation results but also the definition.

What is the difference between ROE and ROIC?

ROE measures how much profit a company as a whole generates from its shareholders' equity. It can be broken down into profit margin, asset turnover, and financial leverage.

DuPont decomposition of ROE

ROE = Net profit margin on sales × Total asset turnover rate × Financial leverage

ROE is important for shareholders, but it can also increase by increasing debt. Therefore, it is difficult to distinguish between the profitability of the business itself and the effect of financial leverage using ROE alone.

ROIC measures how much after-tax operating profit a business generates from its core business relative to the capital invested in the business from both debt and shareholder equity. It is suitable for managing capital efficiency for each business division or segment.

Typical form of ROIC

ROIC = NOPAT ÷ Invested Capital

However, the definitions of NOPAT and invested capital are not uniform. The figures change depending on whether goodwill, lease liabilities, surplus cash, and equity method investments are included. When using a company's own ROIC, it is necessary to specify the calculation formula and adjustment items and make it consistent throughout the period.

Capturing value creation through spreads

The return on capital is more meaningful when viewed in terms of the difference between it and the cost of capital, rather than its individual height.

  • Equity Spread = ROE - Cost of Equity
  • ROIC spread = ROIC－WACC

If the spread is positive, the company is generating returns above the level required by the capital provider. If it is negative, it may mean that even if you are making a profit, you are not generating returns commensurate with the risk.

Furthermore, by multiplying the spread by the amount of capital, the amount of value created can be expressed in monetary terms as residual profit or economic profit. Even if the ratio is high, the monetary effect will be limited if the invested capital is small, and if the ratio is applied to even a small amount of capital, it will have a large impact on corporate value. When comparing business portfolios, it is effective to use both rates and amounts.

PBR and residual profit model

PBR = ROE × PER is an accounting identity, and is the starting point for dividing the reason for low PBR into ROE and PER.

In the residual income model, stock value is expressed as the sum of the current book value of equity and the present value of future residual income.

Equity value = Current book value of equity + Present value of future residual income

Residual profit = (ROE - cost of stockholders' equity) × beginning equity capital

Based on this idea, if the market expects a positive equity spread in the future, PBR will likely exceed 1x, and if it expects a negative spread, it will likely fall below 1x. However, actual PBR is affected by factors such as growth rate, risk, intangible assets that are not recognized in accounting, and non-business assets, so it is not a simple one-to-one correspondence.

Precautions when using CROIC

CROIC is used as an indicator that uses operating cash flow and free cash flow as the numerator of ROIC. However, there is no single standardized definition. The numbers vary greatly depending on whether maintenance investments are deducted, working capital fluctuations are smoothed out, and how M&A is handled.

When disclosing CROIC, be sure to indicate the following three points.

  1. Definition of cash flow used in the numerator.
  2. Definition of invested capital used in the denominator.
  3. How did you handle temporary working capital changes and large investments?

Proprietary indicators are only useful if they have clear definitions, continue to use the same method, and can be used as a bridge with legal indicators.

How to incorporate indicators into management

Good disclosure has more to do with decision-making than a list of metrics.

  • Which WACC or hurdle rate should new investments be reviewed?
  • What decisions should be made to improve or withdraw from existing businesses when ROIC falls below WACC?
  • In M&A, how do you evaluate acquisition price, goodwill, and ROIC after integration?
  • How do you decide on shareholder returns by comparing growth investment opportunities and financial strength?
  • In a medium-term management plan, how should improvements in ROE and ROIC be broken down into profit margin, asset turnover, and invested capital?

The ROIC tree is one way to translate this connection into the field. ROIC is divided into profit margin and invested capital turnover ratio, and further broken down into daily business indicators such as price, product mix, cost, inventory, accounts receivable, and fixed assets. The important thing is not to post diagrams, but to link the actions of each department to corporate value.

Suggestions for IR personnel

  1. Specify who is comparing ROE and ROIC. ROE is compared to cost of shareholders' equity, and ROIC is compared to WACC.
  2. Cost of capital is explained not as a point but as a range with assumptions. Allow disclosure of rf, β, ERP, cost of debt, tax rate, capital structure.
  3. Fix the definition of your own index. Do not change the calculation formula for ROIC or CROIC for each document.
  4. Connect company-wide and business-specific metrics. Shows not only consolidated ROE but also segmental ROIC and improvement measures.
  5. Back up your metrics with decision-making performance. Explain not only the target value but also how it was used for investment, withdrawal, M&A, and return.

Source/reference materials

Related articles

  • 1.1---Why "ROE 8%" became the standard for reform
  • 4.1――How to read PBR1 times decline
  • 4.3 - List of companies disclosed on the TSE - Discipline created by public disclosure
  • 4.4—Seven pitfalls to avoid when disclosing cost of capital
  • 4.5—From disclosure to implementation—April 2026 request update