Updated 5/22/2023

“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, discount, 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 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

What Is The Reinvestment Rate?

The reinvestment rate is the 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 are no fault of the analysts themselves. But it is something to remember when considering analysts’ projected growth rate estimates.

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 a great place to start. But I like to focus on the operating income growth 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 company’s assets, debt, or equity, and the assets and debt help grow the company through 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 its chosen 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.

We can use a simple method to measure how effective adding debt by looking at how well the investment improves the company’s operating earnings. And to compare those earnings, we would look at the operating income growth compared to the interest Visa is paying on its bonds.

If the interest payments remain less than the increase in operating income, you could judge the bond offering as a success.

By determining our reinvestment rate, we can better determine its effectiveness and how much growth we should expect from those reinvestments.

The basic idea around 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 remain below its capital cost, it destroys value with each reinvestment. We must understand the importance of ROIC, its components, and where growth stems from debt or equity.

How Do We Calculate the Reinvestment Rate

The formula for the reinvestment rate:

Reinvestment Rate = (Net Capital Expenditures + Change in WC) / EBIT (1-t)

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 equals NOPAT from the ROIC ratio. We use operating earnings before interest and taxes, then multiply it by the company’s effective tax rate based on our current financial statement.

The numerator offers us a more complicated calculation; 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 remains a bit complicated, but depreciation offers companies a non-cash 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 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, liabilities, and revenues.

Some of this may seem counterintuitive, but think of it this way, operating costs such as materials or inventories remain a function of monies spent on buying more materials to produce a product or to have inventory to sell to customers.

Accountants capture these changes 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 the 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

Proceeds from sales of property and equipment

Depreciation

Net capital investments

And the changes in working capital come 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 10-k; each company may list 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, we have no standardizations of terminology, or a fixed amount of items companies will include in their cash flow statements; other examples might include:

• 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 their reinvestments.

I want to use Target as our guinea pig for our first company. First, we need to locate the financial statements’ data, and I will use the latest 10-k dated January 31, 2022.

The above screenshot allows us to determine our NOPAT, or denominator, for our ratio. Using the following inputs from the income statement:

Item	2022	2021	2020
Operating Income (EBIT)(A)	3,848	8,946	6,539
Taxes (B)	1,178	921	746
Tax rate (B/A)	30.6%	10.3%	11.4%
NOPAT (EBIT*(1-Tax Rate)	2,670	8,024	5,793

Now, let’s look at the numerator of the ratio for Target, using the cash flow statement from the same 10-k.

Now we can determine the numerator using the line items from the cash flow statement above:

Item	2022	2021	2020
+ inventory	403	(3,249)	(1,661)
+ Other Assets	22	(78)	(137)
+Accounts Payable	(2,237)	2628	2,925
+Accured and other liabilities	(624)	(746)	1,931
Changes in working capital	(2,436)	(1,445)	3058

And now, we can calculate the net capital investments from the cash flow statement.

Item	2022	2021	2020
Expenditures for property and equipment	5,528	3,544	2,649
Proceeds from disposal of property and equipment	8	27	42
Depreciation	2,700	2,642	2,485
Net Capital Expenditures	2,820	875	122

To put together our ratio, we take all the above-highlighted information and plug it into our ratio:

Reinvestment rate = Net cap ex + changes in working capital / NOPAT

Item	2022	2021	2020
Net Cap Ex	2,820	875	122
+ ∆ in WC	(2,436)	(1,445)	3,058
NOPAT	2,670	8,024	5,793
Reinvestment Rate	14.38%	(7.1)%	54.89%

The above calculations show that Target reinvested its capital at 14.38% in 2022.

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 add the totals across the board and develop 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 those ideas are great. Use whatever offers you the best process.

In the case of a three-year average, we get:

Net Cap Ex	1,272
∆ in Working Capital	(274)
NOPAT	5,496
3-year Reinvestment Rate	18.2%

Okay, let’s put together a few quick charts to outline this process more with a few other companies.

Visa (V)

Item	2022	2021	2020
EBIT	18,813	15,804	14,081
Tax rate	16.9%	23.7%	20.7%
NOPAT	15,633	12,058	11,166
∆ in WC	-7,670	-6,702	-8,398
Depreciation	861	804	767
Net Capex	970	705	736
Retention Rate	-48.3%	-54.7%	-75.4%
3-year average			-59.4%

Adobe (ADBE)

Item	2022	2021	2020
EBIT	4,237	3,268	2,840
Tax Rate	(25.96)	7.93%	7.27%
NOPAT	5,336	3,008	2,663
∆ in WC	336	285	186
Depreciation	856	788	757
Net Capex	442	330	419
Retention Rate	-1.4%	-5.7%	-6.1
3-year average			-4.4%

The above companies all have strong cash flows, but both operate in capital-light 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, we offer the percentages below:

• Adobe 2022 = $6,550 million versus $7,838 million in operating cash flow, which equates to 83.6%
• Visa 2022 = $11,589 million in repurchases and $3,203 million in dividends for $14,792 million, versus $18,849 million in operating cash flow or 78.5.

For our last example, let’s look at a more capital-intensive company, Lockheed Martin (LMT)

Item	2022	2021	2020
EBIT	8,348	9,123	8,644
Tax Rate	11.4%	13.5%	15.5%
NOPAT	7,396	7,891	7,304
Net Capex	1,766	1,484	1,278
Depreciation	1,404	1,364	1,290
∆ in WC	-585	54	-1,115
Retention Rate	-3.0%	-0.1%	-15.4%%
3-year average			-6.1%

The next step 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	2022
NOPAT (A)	2,670
Book Value of debt (B)	16,123
Book value of equity ©	11,232
ROC (A / B+C)	9.76%
Reinvestment Rate	18.2%
Operating Growth	1.77%

Target’s 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 ten-year periods, which gives a better context.

Remember that 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 in determining a company’s intrinsic value, such as Visa. We have choices when using our DCF models, estimating growth rates from historical performance, or using analysts’ estimates.

As discussed earlier, using both choices brings 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 company’s ability to reinvest.

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 further assist, please don’t hesitate to reach out.

Until next time, take care and be safe out there,

Dave