The Relationship of Growth, ROIC, and Cash Flow  29
not ROIC would determine differences in companies’ cash flow. For reasons 
of simplicity, analysts and academics have sometimes made this assumption. 
But as Chapter 8 demonstrates, returns on invested capital can vary consider-
ably, not only across industries but also between companies within the same 
industry and across time.
The Relationship of Growth, ROIC, and Cash Flow
Disaggregating cash flow into revenue growth and ROIC helps illuminate 
the underlying elements that power a company’s performance. Say a com-
pany’s cash flow was $100 last year and will be $115 next year. This doesn’t 
tell us much about its economic performance, since the $15 increase in cash 
flow could come from many sources, including revenue growth, a reduction 
in capital spending, or a reduction in marketing expenditures. But if we told 
you that the company was generating revenue growth of 7 percent per year 
and would earn a return on invested capital of 15 percent, then you would be 
able to evaluate its performance. You could, for instance, compare the com-
pany’s growth rate with the growth rate of its industry or the economy, and 
you could analyze its ROIC relative to peers, its cost of capital, and its own 
historical performance.
Growth, ROIC, and cash flow are mathematically linked. To see how, con-
sider two companies, Value Inc. and Volume Inc., whose projected earnings, 
investment, and resulting cash flows are displayed in Exhibit 3.2. Earnings, 
in this illustration, are expressed as net operating profit after taxes (NOPAT), 
a term we use throughout the book. Both companies earned NOPAT of $100 
million in year 1 and are expected to increase their revenues and earnings at 5 
percent per year, so their projected earnings are identical. If the popular view 
that value depends only on earnings were true, the two companies’ values 
also would be the same. But this simple example demonstrates how wrong 
that view can be.
EXHIBIT 3.2  Tale of Two Companies: Same Earnings, Different Cash Flows
$ million
Value Inc.
Year 1
Year 2
Year 3
Year 4
Year 5
NOPAT1
100
105
110
116
122
Investment
(25)
(26)
(28)
(29)
(31)
Cash flow
75
79
82
87
91
Volume Inc.
Year 1
Year 2
Year 3
Year 4
Year 5
NOPAT1
100
105
110
116
122
Investment
(50)
(53)
(55)
(58)
(61)
Cash flow
50
52
55
58
61
1 Net operating profit after taxes.

30  Fundamental Principles of Value Creation
Almost all companies need to invest in plant, equipment, or working capi-
tal to grow. Free cash flow is what’s left over for investors once investments 
have been subtracted from earnings. Value Inc. generates higher free cash 
flows with the same earnings because it invests only 25 percent of its profits—
its investment rate—to achieve the same profit growth as Volume Inc., which 
invests 50 percent of its profits. Value Inc.’s lower investment rate results in 
50 percent higher cash flows each year than Volume Inc. sees while generating 
the same level of profits.
We can value the two companies by discounting their future free cash 
flows at a discount rate that reflects what investors expect to earn from in-
vesting in the companies—that is, their cost of capital. For both companies, 
we assumed their growth and investment rates were perpetual, and we dis-
counted each year’s cash flow to the present at a 10 percent cost of capital. So, 
for example, Value Inc.’s year 1 cash flow of $75 million has a present value of 
$68 million today (see Exhibit 3.3). We summed each year’s results to derive 
a total present value of all future cash flows: $1,500 million for Value Inc. and 
$1,000 million for Volume Inc.
The companies’ values can also be expressed as price-to-earnings ra-
tios (P/Es). Divide each company’s value by its first-year earnings of $100 
million. Value Inc.’s P/E is 15, while Volume Inc.’s is only 10. Despite 
identical earnings and growth rates, the companies have different earn-
ings multiples because their cash flows are so different. Value Inc. gener-
ates higher cash flows because it doesn’t have to invest as much as Volume 
Inc. does.
Differences in ROIC—defined here as the incremental NOPAT earned 
each year relative to the prior year’s investment—are what drives difference 
in investment rates. In this case, Value Inc. invested $25 million in year 
EXHIBIT 3.3  Value Inc.: DCF Valuation
$ million
Value Inc.
Year 1
Year 2
Year 3
Year 4
Year 5
Year X
Sum
NOPAT1
100
105
110
116
122
…
Investment
(25)
(26)
(28)
(29)
(31)
…
Cash flow
75
79
82
87
91
…
Value today
68
65
62
59
56
…
1,500
Present value of 75 
discounted at 10% for 
1 year
Present value of 87 
discounted at 10% for 
4 years
1 Net operating profit after taxes.