What is the Reinvestment Rate?
The Reinvestment Rate measures the percentage of a company’s after-tax operating income (i.e. NOPAT) that is allocated to capital expenditures (CapEx) and net working capital (NWC).
- What is the definition of the reinvestment rate?
- How can the reinvestment rate be calculated?
- What is the relationship between the reinvestment rate and return on capital?
- For which types of companies is the reinvestment rate most accurate?
Table of Contents
How to Calculate the Reinvestment Rate
The expected growth rate in operating income is a byproduct of the reinvestment rate and the return on invested capital (ROIC).
- Reinvestment Rate: The proportion of NOPAT re-invested into capital expenditures (CapEx) and net working capital (NWC).
- Return on Invested Capital (ROIC): The profitability (%) earned by a company using its equity and debt capital.
The calculation of the reinvestment rate is a three-step process:
- First, we calculate net CapEx, which is equal to capital expenditures minus depreciation.
- Next, the change in net working capital (NWC) is added to the result from the prior step, representing the dollar amount of reinvestments.
- Lastly, the value of the reinvestments is divided by the tax-affected EBIT, i.e. net operating profit after taxes (NOPAT).
Reinvestment Rate Formula
The formula for calculating the reinvestment rate is as follows.
Reinvestment Rate Formula
The formula for calculating the reinvestment rate is shown below.
- Reinvestment Rate = (Net CapEx + Change in NWC) / NOPAT
- Net CapEx = CapEx – Depreciation
- NOPAT = EBIT / (1 – Tax Rate)
The change in NWC is considered a reinvestment because the metric captures the minimum amount of cash necessary to sustain operations.
- Increase in NWC ➝ Less Free Cash Flow (FCF)
- Decrease in NWC ➝ More Free Cash Flow (FCF)
Note the net working capital (NWC) excludes cash & cash equivalents, as well as debt and any related interest-bearing liabilities.
Reinvestment Rate Impact on Expected Growth
Once calculated, the expected growth in operating income (EBIT) can be calculated by multiplying the reinvestment rate by the return on invested capital (ROIC).
Expected Operating Income Growth Formula
- Expected EBIT Growth = Reinvestment Rate * ROIC
In practice, the reinvestment rate of a company can be compared to that of industry peers, as well as a company’s own historical rates.
Companies with higher reinvestment rates should exhibit higher operating profit growth – albeit, the growth might require time to realize.
If a company consistently has high reinvestment rates, yet its growth lags behind peers, the takeaway is that the capital allocation strategy of the management team could be sub-optimal.
While increased spending by a company can drive future growth, the strategy behind where the capital is being spent is just as important.
A low reinvestment rate could also just mean that the company is more mature, as reinvestments rates tend to decline in the later stages of the company life cycle.
Reinvestment Rate Calculator – Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Reinvestment Rate Calculation Example
For our illustrative scenario, we will calculate the reinvestment rate of a company using the following assumptions.
Year 1 Financials
- CapEx = $2 million
- Depreciation = $1.6 million
- Net Working Capital (NWC) = $800k
Year 2 Financials
- 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.
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
Remember, a negative change in NWC is a cash “outflow,” so the –$40k increases the reinvestment needs of our company.
With the numerator complete, the final step before arriving at the reinvestment rate 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.