Reinvestment and the Value Drivers
Firm value is a function of three value drivers: how fast cash flows grow, the return on invested capital (ROIC) earned on new investment, and the WACC they are discounted at. Growth funded at a ROIC above WACC adds value, while the same growth at a ROIC below WACC subtracts it. The link runs through the reinvestment rate, since , so a firm can only grow faster by reinvesting more of its operating cash. The McKinsey key value driver formula prices a steadily growing business directly from these inputs, separating the growth that pays from the growth that does not.
Try it yourself
A firm creates value only when ROIC > WACC. With constant growth g, NOPAT and a constant ROIC, the plough-back rate is g / ROIC and the value is V = NOPAT·(1 − g/ROIC) / (WACC − g). Compare it with the no-growth value NOPAT / WACC: growth lifts the value above the benchmark only when ROIC clears the cost of capital, and drags it below when ROIC falls short.
Hold g fixed and slide ROIC across WACC. Above WACC the gold curve rises with g; below it the curve turns rose and falls; exactly at WACC it lies flat on the no-growth line.
Reflect: a fast-growing firm with ROIC below its WACC is worth less than if it stopped growing entirely. Why, then, do markets sometimes reward growth for its own sake, and how long can a firm sustain ROIC above WACC before competition closes the gap?
Why it matters
Two firms can both grow profit at 6 percent a year and look identical from the outside. Inside, one reaches that growth by reinvesting cheaply at a high return, the other by pouring in vast capital at a thin return. The value-driver lens splits them. Growth is not free, it is bought with reinvested cash, and whether it is worth buying depends entirely on the ROIC it earns relative to WACC. The formula makes the point vivid: lift growth while ROIC sits below WACC and the value actually falls.
Formulas
Worked examples
A firm expects NOPAT of A$100m next year, grows at 4 percent, earns a ROIC of 16 percent, and has a WACC of 9 percent. What is it worth, and how does value change if ROIC instead equals WACC?
The reinvestment share is g over ROIC, that is 0.04 over 0.16, which is 0.25, so free cash flow is A$100m times 0.75, which is A$75m. Value is A$75m divided by (0.09 minus 0.04), which is A$75m over 0.05, about A$1,500m. Now set ROIC to 9 percent. The bracket becomes 1 minus 0.04 over 0.09, about 0.556, free cash flow is A$55.6m, and value falls to A$55.6m over 0.05, about A$1,111m. Same growth, far less value, because growth at ROIC equal to WACC creates nothing.
Common mistakes
- ✗Faster growth always raises value. Growth only adds value when ROIC exceeds WACC. When ROIC is below WACC, more growth destroys more value.
- ✗Growth comes for free. Growth must be funded by reinvesting operating cash, so a higher growth rate lowers the share of NOPAT that reaches investors as free cash flow.
- ✗A high ROIC alone guarantees a high value. ROIC must be paired with reinvestment to turn into growth, and the value also depends on how that growth compares with WACC.
- ✗The three drivers act independently. Growth, ROIC and WACC interact, since growth is itself ROIC times the reinvestment rate, so they cannot be tuned one at a time.
Revision bullets
- •Value is driven by growth, ROIC and WACC together
- •Growth equals ROIC times the reinvestment rate
- •The value-driver formula prices a steadily growing firm from these inputs
- •Growth adds value only when ROIC exceeds WACC
- •Higher growth means a higher reinvestment rate and less free cash flow
- •When ROIC equals WACC, extra growth creates no value
Quick check
In the key value driver formula, raising the growth rate while ROIC stays below WACC will
A firm earns a ROIC of 20 percent and reinvests 30 percent of its NOPAT. Its sustainable growth rate is about
Connected topics
Sources
- Koller, Goedhart & Wessels (2020)Koller, T., Goedhart, M., & Wessels, D. Valuation: Measuring and Managing the Value of Companies. 7th ed. McKinsey & Company / Wiley, 2020.Develops the key value driver formula and the growth, ROIC and cost-of-capital triad.
- Titman & Martin, Ch. 7Titman, S., & Martin, J. D. Valuation: The Art and Science of Corporate Investment Decisions. Pearson.Frames the multi-year nature of value creation and the reinvestment needed to fund growth.