Reinvestment Rate

How Reinvestment Impacts Expected Growth (EBIT)

Once calculated, the expected growth in operating income (EBIT) can be calculated by multiplying the rate of reinvestment by the return on invested capital (ROIC).

In practice, a company’s implied rate of reinvestment can be compared to that of industry peers, as well as a company’s own historical rates.

Companies with higher reinvestment activity should exhibit higher operating profit growth – albeit, the growth might require time to realize.

If a company consistently has an above-market rate of reinvestment, yet its growth lags behind peers, the takeaway is that the capital allocation strategy of the management team could be suboptimal.

While increased spending by a company can drive future growth, the strategy behind where the capital is being spent is just as important.

A clear trend of reduced reinvestment, in contrast, could simply mean that the company is more mature, as reinvestment opportunities tend to decline in the later stages of a company’s life cycle.

Learn More → Reinvestment Rate and Growth by Industry (Damodaran)

Reinvestment Rate Calculator – Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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Step 1. Capex, Depreciation and Net Working Capital Assumptions

Suppose we’re tasked with calculating the reinvestment rate of a company using the following assumptions.

Financials, Year 1:

• Capex = $2 million
• Depreciation = $1.6 million
• Net Working Capital (NWC) = $800k

Financials, Year 2:

• Capex = $2.5 million
• Depreciation = $2.0 million
• Net Working Capital (NWC) = $840k

From the financials listed above, we can reasonably assume the company is relatively mature, given how depreciation as a percentage of CapEx is 80%.

If the company were unprofitable at the operating income line, using the reinvestment rate is not going to be feasible.

Step 2. Reinvestment Rate Calculation Analysis

The change in NWC is equal to –$40k, which represents a cash outflow (“use” of cash), as more cash is tied up in operations.

• Change in Net Working Capital (NWC) = $800k Prior Year NWC – $840k Current Year NWC
• Change in NWC = –$40k

Since a negative change in NWC is a cash “outflow,” the -$40k increases the reinvestment needs of our company.

With the numerator complete, the final step before arriving at our company’s rate of reinvestment is calculating the tax-affected EBIT, or “NOPAT”.

Here, we assume our company had $20 million in EBIT for Year 2, which at a 25% tax rate, results in $15 million of NOPAT.

In closing, the reinvestment rate of our company is 3.6%, which we calculated by dividing the sum of the net Capex and the change in NWC by NOPAT.