Intrinsic Value, Part 5: Where the Growth Rate Comes From
We don’t guess at growth. We derive it.
In Part 4, we calculated Maple Ridge Manufacturing’s free cash flow to the firm: $32.5 million. That’s the cash the business generated this year.
To find what the business is worth today, we need to project that number forward — how much free cash flow will Maple Ridge generate next year, and the year after, and the year after that? To do that, we need a growth rate.
This is where a lot of valuation models go wrong. And it’s worth understanding why before we show you how we do it differently.
Why We Don’t Use Analyst Estimates
The most common approach is to look up what Wall Street analysts are projecting for a company’s earnings growth — usually a 5-year estimate — and use that number.
The problem: analyst estimates are opinions, not measurements. They are based on interviews with management, industry comparisons, and a fair amount of guesswork. Studies have consistently shown that analyst growth estimates are optimistic, and that they become less accurate the further out they go. Using them as the foundation of a valuation model is like navigating by a map someone drew from memory.
A second approach is to use the company’s historical revenue or earnings growth rate — whatever it grew at over the past five or ten years. This is better, but it still has a flaw: past growth doesn’t tell you whether the business can sustain that growth going forward. A company that grew 20% per year for a decade may have been burning through savings to do it.
We want something grounded in the actual economics of the business. Something we can measure. That means looking at two things the company reports directly: how much it reinvests, and what it earns on those investments.
The Two Inputs
Return on Invested Capital (ROIC) is the rate of return the business earns on every dollar it has invested in its operations. It answers the question: for every dollar this business puts to work, how much does it earn back?
ROIC = EBIAT ÷ Invested Capital
Invested Capital is the total amount of money deployed in the business — equity from shareholders plus debt from lenders, minus cash that’s sitting idle and not being put to work.
Invested Capital = Book Equity + Total Debt − Cash
A business with high ROIC is compounding its investors’ money efficiently. A business with low ROIC is spinning its wheels — it may be growing in size but not in value.
Reinvestment Rate measures how much of the company’s after-tax operating profit gets put back into the business rather than paid out. It captures CapEx (minus the depreciation on existing assets), plus any increase in working capital, expressed as a fraction of EBIAT.
Reinvestment = CapEx − D&A + Change in Working Capital
Reinvestment Rate = Reinvestment ÷ EBIAT
A business that reinvests aggressively is betting that growth will be worth it. A business that reinvests little is either mature and distributing cash to owners, or struggling to find opportunities worth pursuing.
The Formula
Put those two inputs together and you get the fundamental growth rate:
Growth Rate = Reinvestment Rate × ROIC
The intuition is straightforward: growth comes from putting money back into the business, multiplied by how productively the business uses that money. If you reinvest a lot into a high-return business, you get fast growth. If you reinvest into a low-return business, you get slow growth even if you’re spending heavily. If you barely reinvest at all, you get slow growth regardless of how efficient the business is.
Three Scenarios
The capital trap. A business reinvests 60% of its EBIAT, but earns only 5% ROIC. Growth rate = 60% × 5% = 3%. This company is pouring money back into the business but getting almost nothing for it. It’s growing in size, but not in value — and the DCF model will reflect that.
The efficient but slow compounder. A business earns 25% ROIC but only reinvests 10% of earnings — it pays most of its profit out as dividends. Growth rate = 10% × 25% = 2.5%. The business is excellent at what it does, but it’s not expanding aggressively. Steady, not spectacular.
The sweet spot. A business earns 20% ROIC and reinvests 40% of earnings. Growth rate = 40% × 20% = 8%. This is the kind of business value investors look for — one that earns well above its cost of capital and keeps finding good uses for its retained earnings.
The Maple Ridge Example
Let’s continue with Maple Ridge Manufacturing from Part 4. We already calculated the operating numbers — EBIT, tax rate, EBIAT, CapEx, D&A, and working capital. Now we’ll add the balance sheet data we need for Invested Capital.
Step 1 — EBIAT (from Part 4):
EBIT = $50.0 million
Tax rate = 25%
EBIAT = $50.0M × (1 − 0.25) = $50.0M × 0.75 = $37.5 million
Step 2 — Reinvestment (from Part 4):
CapEx (5-yr average) = $10.0M
D&A = $ 8.0M
Change in NWC = $ 3.0M
Reinvestment = $10.0M − $8.0M + $3.0M = $5.0 million
Reinvestment Rate = $5.0M ÷ $37.5M = 13.3%
Step 3 — Invested Capital (from balance sheet):
Book Equity = $130M
Total Debt = $ 45M (short-term + long-term)
Cash = $ 25M
Invested Capital = $130M + $45M − $25M = $150 million
Step 4 — ROIC:
ROIC = $37.5M ÷ $150M = 25%
Step 5 — Growth Rate:
Growth Rate = 13.3% × 25% = 3.3%
Maple Ridge reinvests about 13 cents of every dollar of after-tax operating profit. It earns a strong 25% return on its invested capital — typical of a manufacturing business that has been around long enough to depreciate much of its asset base. Multiply the two together and you get a fundamental growth rate of about 3.3%.
That’s a modest number, but it’s honest. Maple Ridge is an established business. Its capital expenditures barely exceed its depreciation, meaning it isn’t building a lot of new capacity. The low reinvestment rate limits growth, even though the business is quite efficient with the capital it does deploy.
The 30% Cap
The formula can produce high growth rates for exceptional businesses — a company reinvesting 80% of earnings at 50% ROIC would compute to 40% annual growth. We cap the implied growth rate at 30%.
Why? Because sustaining very high growth for five straight years is extraordinarily rare. A 30% cap keeps the model honest and prevents a single exceptional year from inflating the valuation into unrealistic territory. If a business truly grows at 30%+ for five years, the cap is conservative — but being conservative is the point.
The One-Sentence Summary
The growth rate in our model isn’t a forecast or an opinion — it’s the product of two things the business reports: how much it reinvests, and what it earns on those investments.
Next: Part 6 — Risk and the Discount Rate. We have a cash flow and a growth rate. Now we need the rate we’ll use to discount those future dollars back to today. That rate comes from measuring the risk of the business — and it’s more precise than it sounds.
— Jim