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Reinvestment Rate

Guide to Understanding the Reinvestment Rate

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Reinvestment Rate

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).

The calculation of the rate of a company’s reinvestment is a three-step process:

Reinvestment Rate Formula

The formula for calculating the reinvestment rate is as follows.

Reinvestment Rate = (Net Capex + Change in NWC) / NOPAT

Where:

  • 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)

Side Note: The net working capital (NWC) excludes cash and cash equivalents, as well as debt and any related interest-bearing liabilities.

How Reinvestment Impacts Expected Growth (EBIT)

Once calculated, the expected growth in operating income (EBIT) can be calculated by multiplying the rate of reinvestment by the return on invested capital (ROIC).

Expected EBIT Growth = Reinvestment Rate * ROIC

In practice, a company’s implied rate of reinvestment can be compared to that of industry peers, as well as a company’s own historical rates.

Companies with higher reinvestment activity should exhibit higher operating profit growth – albeit, the growth might require time to realize.

If a company consistently has an above-market rate of reinvestment, 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 clear trend of reduced reinvestment, in contrast, could simply mean that the company is more mature, as reinvestment opportunities tend to decline in the later stages of a company’s life cycle.

Learn More → Reinvestment Rate and Growth by Industry (Damodaran)

Reinvestment Rate Calculator – Excel Model Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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Step 1. Capex, Depreciation and Net Working Capital Assumptions

Suppose we’re tasked with calculating the reinvestment rate of a company using the following assumptions.

Financials, Year 1:

  • Capex = $2 million
  • Depreciation = $1.6 million
  • Net Working Capital (NWC) = $800k

Financials, Year 2:

  • 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.

Step 2. Reinvestment Rate Calculation Analysis

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

Since a negative change in NWC is a cash “outflow,” the -$40k increases the reinvestment needs of our company.

With the numerator complete, the final step before arriving at our company’s rate of reinvestment 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.

Reinvestment Rate Calculator

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Marcial
Marcial
August 10, 2022 6:37 pm

Hello, nice work!!
I would like to ask; If the Change in WC were +40 instead of -40, would you add it to Net CAPEX or would you subtract it from the Net CAPEx?
Thanks

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