Valuation course · Lesson 3 of 10
Growth adds value only when new capital earns more than the hurdle.
Growth is not free. A company must invest to grow, and the return on that investment decides whether growth adds value.
Profit on the capital in the business
Operating income after tax is $142.2 million. Analysts call it NOPAT. The capital in the business is working capital plus property and equipment, $500 million. So the return on invested capital is 28.4%.
The growth identity
Reinvestment is capital expenditure less depreciation, plus the increase in working capital. For Example Co., that is $47.4 million, or 33.3% of NOPAT.
Growth equals the reinvestment rate times the return on new capital. Example Co. grew 8% and reinvested 33.3%. So its new capital earned 24.0%.
Cash flow is what the company does not reinvest. That is NOPAT times one minus growth divided by the return on new capital: $142.2 million times (1 - 8% / 24%), or $94.8 million. It matches lesson 2.
When growth adds value
| Return on new capital | 2% growth | 4% growth | 6% growth |
|---|---|---|---|
| 9% | 11.1x | 11.1x | 11.1x |
| 15% | 12.4x | 14.7x | 20.0x |
| 25% | 13.1x | 16.8x | 25.3x |
The table shows a fair price to earnings ratio for a company in steady state, at a 9% hurdle. When new capital earns 9%, the same as the hurdle, growth adds nothing. Every column gives 11.1 times.
When new capital earns 25%, faster growth adds a lot. When it earns less than the hurdle, growth takes value away. So ask two questions about growth: how much, and at what return.
Key points
- Growth equals the reinvestment rate times the return on new capital.
- Cash flow is the part of profit that the company does not reinvest.
- Growth adds value only when new capital earns more than the hurdle.