“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.”
– Warren Buffett, 1992 Berkshire Hathaway Shareholder Letter
Finding companies that compound their returns on invested capital over long periods while growing simultaneously is the “golden goose” we are all trying to find. One way to help find these great companies is to use intrinsic valuation models such as a DCF. One problem with using models such as a DCF is the assumptions we need to input, such as a growth estimate.
We have choices when deciding on growth rates, discount rates, and terminal rates. With growth rates, we have three routes to choose from, and in this post, we will talk about the “choosing wisely” route, growth rates from fundamentals in the form of the reinvestment rate.
Return on invested capital is one of the best tools we have to measure how efficiently a company reinvests its capital to grow revenues. Using parts of the ratio helps us determine what kind of real growth we can expect from Visa, for example.
In today’s post, we will learn:
 What Is The Reinvestment Rate?
 How Do We Calculate Reinvestment Rate?
 Examples of Reinvestment Rate
 Investor Takeaway
What Is The Reinvestment Rate?
The reinvestment rate is the amount of growth we expect from any free cash reinvestment in an investment. For example, if we reinvest our cash in a company, we expect that cash to grow our investment to a higher level.
We express the reinvestment rate as a ratio, which allows us to compare it to other investment choices for our cash.
As I mentioned a moment ago, there are three main ways to determine what kind of growth we can expect from a company:
 Historical
 Analyst
 Fundamental
And with the first two, historical and analyst, growth is not a function of its operating details. Instead, they are a function of events in the past or based on biases, which we all have and is no fault of the analysts themselves. But it is something to keep in mind when considering analyst’s estimates of projected growth rates.
A better way is to look at how a company reinvests for growth and the quality of those reinvestments.
There are many growth determinants, and some of the focus on equity, earning, and net income is great places to start. But I like to focus on the growth of the operating income because that is its operations function.
The reinvestment rate takes elements from the ROIC ratios such as NOPAT (net operating profit after taxes) to determine how well the company reinvests. The better the company reinvests, the more growth it will drive.
Growth derives its power from the assets, debt, or equity of the company, and the assets and debt help grow the company by the effectiveness of those investments.
For example, let’s say that Visa takes on more debt in the form of a bond offering. By selling its debt in the company, Visa can raise cash to invest in their choosing project. Maybe they choose to develop a new product or technology to gain more market share or new customers. Or maybe they choose to acquire a company that adds more to their value.
A simple way to measure how effective that addition of debt is to measure how well that investment improves the company’s operating earnings. And to compare those earnings, we would look at the growth of the operating income compared to the interest Visa is paying on its bonds. If the interest payments are less than the increase in operating income, you could judge that bond offering a success.
By determining our reinvestment rate, we can better determine its reinvestments’ effectiveness and how much growth we should expect from those reinvestments.
The basic idea around all of these ratios and formulas is to build value and growth, compared to the cost of capital or how much it costs to grow. If the company’s reinvestment rates are below its capital cost, the company is destroying value with each reinvestment. It is important to understand the importance of ROIC and its components and where growth is coming from, debt or equity.
How Do We Calculate Reinvestment Rate
The formula for the reinvestment rate:
Reinvestment Rate = (Net Capital Expenditures + Change in WC) / EBIT (1t)
From the above formula, we will need to determine four components:
 Net capital expenditures
 Changes in Working Capital
 EBIT or earnings before interest and taxes
 Taxes
The formula’s denominator comes from the company’s income statement and is NOPAT from the ROIC ratio. It is operating earnings before interest and taxes, and then we multiply it by the company’s effective tax rate based on the current financial statement we are using.
The numerator is a touch more complicated; we take the net capital investments and changes in working capital from the cash flow statement and subtract depreciation from the net capital expenditures. Depreciation is a bit complicated, but depreciation is a noncash way of accounting for the expense of buying equipment for the company.
A simple way to think of it is if you buy an office chair, instead of paying $500 cash for it, you account for $100 each year until the item is “paid” off. Therefore, we need to subtract it from the net capital expenditures to arrive at our net cash outflow or inflow for capital expenditures.
Both the net capital investments and working capital changes are the company’s functions taking cash flows and reinvesting those back into the business to grow revenues. For example, if Microsoft is spending money on computers or other investments that drive more revenues for the company, all the better.
We can measure those cash reinvestments by looking at both net capital expenditures and changes in working capital. The working capital changes from the operating cash flows and net capital investments come from investing cash flows. Both sections flow back and forth from the balance sheet, which drives Microsoft’s assets and liabilities, which drives revenues.
Some of this may seem counterintuitive, but think of it this way, operating costs such as materials or inventories are a function of monies spent on buying more materials to produce a product or to have inventory to sell to customers.
Those changes are captured in the cash flow statement as the company spends more money on those items or receives cash from the use or sale of those items. It is a constant ebb and flow between the cash flow statement and balance sheet.
Net capital investments will contain, which comes from the Cash Flow from Investing section of the cash flow statement:
Investments in property and equipment 


Net capital investments 
And the changes in working capital comes from the Cash Flow from Operations section of the cash flow statement:
Changes in working capital 
Inventory 
Other Assets 
Accounts payable 
Accrued and other liabilities 
The above is an example of the line items from Target’s 10k, but each company may list out more line items for the working capital, depending on their operations’ nature. Some companies may only list the capital investments as net, meaning the calculations of the sale of PPE are done for you.
For most companies, the inventory and accounts payable accounts will be the largest and impact the business the most.
Unfortunately, there are no standardizations of terminology or a fixed amount of items companies will include in their cash flow statements; other examples might be:
 Accounts receivable
 Client incentives
 Settlement receivable
 Settlement payable
Examples of Reinvestment Rate
Let’s look at some companies and determine the reinvestment rate to see how much fundamental growth we can expect from its reinvestments.
For our first company, I would like to use Target as our guinea pig. The first step will be to locate the financial statements’ data, and I will use the latest 10k dated January 31, 2021.
The above screenshot allows us to determine our NOPAT, or denominator for our ratio. Using the following inputs from the income statement:
Item  2020  2019  2018 
Operating Income (EBIT)  6,539  4,658  4,110 
EBT (A)  5,546  4,190  3,676 
Taxes (B)  1,178  921  746 
Tax rate (B/A)  21.24%  21.98%  20.29% 
NOPAT (EBIT*(1Tax Rate)  5,150  3,634  3,276 
Now, let’s look at the numerator of the ratio for Target, using the cash flow statement from the same 10k.
Now we can determine the numerator using the line items from the cash flow statement above:
Item  2020  2019  2018 
+ Inventory  (1,661)  505  (900) 
+ Other Assets  (137)  18  (299) 
+Accounts Payable  2,295  140  1,127 
+Accured and other liabilities  1,931  199  89 
Changes in working capital  2,428  862  17 
And now, we can calculate the net capital investments from the cash flow statement.
Item  2020  2019  2018 
Expenditures for property and equipment  2,649  3,027  3,516 
 42  63  85 
Depreciation  2,485  2,604  2,474 
Net Capital Expenditures  122  360  957 
To put together our ratio, we take all the abovehighlighted information and plug it into our ratio:
Reinvestment rate = Net cap ex + changes in working capital / NOPAT
Item  2020  2019  2018 
Net Cap Ex  122  360  957 
+ ∆ in WC  2,428  862  17 
NOPAT  5,150  3,634  3,276 
Reinvestment Rate  49.51%  33.62%  29.73% 
The above calculations tell us that Target reinvests its capital back at a rate of 49.51% in 2020. A good practice when calculating these rates is to look at them over multiple years; otherwise, one great year might skew the results; likewise, a bad year might skew them the other way. You could simply add the totals across the board and come up with a compound rate over the three years of the financials. Or you could look at a longer period, say ten years and take a median; all of those ideas are great. Use whatever is best for your process.
In the case of a threeyear average, we get:
Net Cap Ex  1,439 
∆ in Working Capital  3,307 
NOPAT  12,060 
3year Reinvestment Rate  39.3% 
Okay, let’s put together a few quick charts to outline this process a bit more with a few other companies.
Visa (ADBE)
Item  2020  2019  2018 
EBIT  14,125  15,438  13,604 
Tax rate  21.20%  18.84%  19.56% 
NOPAT  11,130  12,259  10,943 
∆ in WC  720  279  2220 
Depreciation  767  656  613 
Net Capex  736  756  718 
Retention Rate  6.19%  3.09%  21.24% 
3year Average  10.14% 
Adobe (ADBE)
Item  2020  2019  2018 
EBIT  4,237  3,268  2,840 
Tax Rate  (25.96)  7.93%  7.27% 
NOPAT  5,336  3,008  2,663 
∆ in WC  542  51  574 
Depreciation  571  586  346 
Net Capex  419  395  267 
Retention Rate  7.30%  (4.65)  18.58% 
3year Average  7.08% 
The above companies all have strong cash flows, but both are in capitallight businesses, and reinvestment comes in the form of R&D for both companies’ operating incomes and don’t flow to the cash flow statements.
And digging a little deeper, you can see that both companies return quite a bit of their operating cash flows in the form of dividends or share repurchases; in the case of Adobe and Visa, the percentages are below:
 Adobe 2020 = $3,371 million versus $5,727 million in operating cash flow, which equates to 58.9%
 Visa 2020 = $8,274 million in repurchases and $2,664 million in dividends for a total of $10,938 million, versus $10,440 million in operating cash flow or 104.7%, which tells us that the company paid out more cash to shareholders than it created in 2020.
For our last example, let’s look at a more capital intensive company, Lockheed Martin (LMT)
Item  2020  2019  2018 
EBIT  8,877  7,698  6,644 
Tax Rate  16.36%  13.96%  13.57% 
NOPAT  7,424  6,623  5,742 
Net Capex  1,766  1,484  1,278 
Depreciation  1,124  1,078  1,055 
∆ in WC  200  426  48 
Retention Rate  11.34%  12.56%  4.71% 
3year average  9.54% 
The next step along the path is to take the retention rate and determine a company’s growth rate based on its reinvestment rate. To do that, we use the following formula:
Operating income growth = reinvestment rate*Return on Capital.
The return on capital is calculated by looking at the NOPAT divided by the debt plus equity.
Let’s use the above companies’ examples to find the growth rates from their fundamentals.
Target:
Item  2020 
NOPAT (A)  5,150 
Book Value of debt (B)  13,754 
Book value of equity ©  14,440 
ROC (A / B+C)  18.26% 
Reinvestment Rate  49.51% 
Operating Growth  9.04% 
Visa:
Item  2020 
NOPAT  11,130 
Book value of debt  21,071 
Book value of equity  36,210 
ROC  19.43% 
Reinvestment rate  6.19% 
Operating growth  1.2% 
 Adobe operating growth 2020 = 2.24%
 Lockheed Martin growth 2020 = 4.75%
Both growth rates are from a short period, one year, and a better option would be to work out the ratios over longer periods, such as five or tenyear periods, which gives a better context. Keep in mind 2020/2021 will contain the Covid year, which will skew any calculations, depending on the company.
Investor Takeaway
Estimating growth rates is one of the multiple difficulties involved in determining a company’s intrinsic value, such as Visa. We have choices when using our DCF models, estimating growth rates from the historical performance, or using analysts’ estimates.
As we discussed earlier, using both of those choices brings in problems particular to human biases and based on past performances.
One of the advantages of using a reinvestment rate based on the company’s fundamentals is it brings in the efficiency of the company’s capital investments. The better a company reinvests, the more growth it will develop. Studies have shown that the best investments are companies that can reinvest at high rates of return, i.e., return on invested capital.
We also want companies that create those reinvestment opportunities and growth at higher rates than their costs of capital. If the company is earning returns less than those returns, it destroys value over the long run. Those are companies we want to avoid at all costs.
Putting together the reinvestment rate components is a simple process, and it lays out how the company is reinvesting in its business. It gives you a reasonable growth rate based on the companies ability to reinvest in itself.
With that, we will wrap up our discussion for today.
As always, thank you for taking the time to read today’s post, and I hope you find something of value in your investing journey. If I can be of any further assistance, please don’t hesitate to reach out.
Until next time, take care and be safe out there,
Dave
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