The Growth = ROIC x Reinvestment Identity

Two companies both grow revenue 15% a year. One is compounding value for shareholders; the other is destroying it, quietly, one reinvested dollar at a time. Growth alone tells you nothing about which is which — you also need to know what the company earns on the capital it plows back in. That relationship is not a rule of thumb; it is an accounting identity that must hold, given a company's definitions of profit and reinvestment.

The identity

$$g = \text{ROIC} \times \text{Reinvestment Rate}.$$

In words: a company's growth rate equals the return it earns on invested capital multiplied by the fraction of its profit it puts back into the business rather than paying out.

ROIC (return on invested capital) is after-tax operating profit divided by the capital employed to generate it — the plant, working capital, and acquired assets, funded by both debt and equity. Reinvestment rate is the share of after-tax operating profit spent on net capital expenditure and working-capital growth, rather than distributed as dividends or buybacks. Multiply the two and you get exactly how fast operating profit — and, if margins hold, revenue — can grow without the company raising outside capital.

Company B ROIC 6% reinvest 100% g = 6% × 100% = 6%

A worked example

Company A earns $100m of after-tax operating profit on $500m of invested capital, so ROIC = 100/500 = 20%. It reinvests $30m (new stores, some working capital) and pays out the rest as dividends, so its reinvestment rate is 30/100 = 30%. Its growth rate is $20\% \times 30\% = 6\%$.

Company B earns $30m of after-tax operating profit on $500m of invested capital — a much weaker ROIC = 6% — and has to reinvest every dollar of that profit ($30m) just to keep expanding, a reinvestment rate of 100%. Its growth rate is also $6\% \times 100\% = 6\%$.

Both companies grow 6% a year. But Company A only needs 30 cents of every profit dollar to fund that growth and hands the rest back to shareholders, while Company B needs every cent and still can't grow faster than its low-return capital allows. If both are priced on a simple growth multiple, the market is paying the same price for very different businesses — one throwing off cash, the other consuming it just to stand still.

Where it matters in a valuation

This identity is how analysts sanity-check a growth assumption in a DCF instead of typing in a number that "feels right." If you assume 3-year revenue growth of 12% but the company's historical ROIC is 8% and it only reinvests 40% of profit, the identity says maximum sustainable growth is $8\% \times 40\% = 3.2\%$ — the 12% assumption implies either a large jump in ROIC, a much higher reinvestment rate (funded by new debt or equity), or both. It also explains terminal value: in perpetuity, a firm cannot grow faster than the overall economy without reinvesting an ever-larger share of profit, which is why terminal growth rates are capped near long-run GDP growth.

It cuts the other way too. A mature, high-ROIC business that reinvests very little — a royalty-like model — can still be a phenomenal investment at a low growth rate, because nearly all its profit converts to free cash returned to owners rather than being trapped funding expansion.