The Relationship of Growth, ROIC, and Cash Flow  31
1 to increase its profits by $5 million in year 2. Its return on new capital 
is 20 percent ($5 million of additional profits divided by $25 million of 
investment).3 In contrast, Volume Inc.’s return on invested capital is 10 
percent ($5 million in additional profits in year 2 divided by an investment 
of $50 million).
Growth, ROIC, and cash flow (as represented by the investment rate) are 
tied together mathematically in the following relationship:
Growth
ROIC
Inve ment Rate
=
×
st
Applying the formula to Value Inc.:
5
20
25
%
%
%
=
×
Applying it to Volume Inc.:
5
10
50
%
%
%
=
×
As you can see, Volume Inc. needs a higher investment rate to achieve the 
same growth.
Another way to look at this comparison is in terms of cash flow:
Cash Flow
Earnings
Investment Rate
=
×
−
(
)
1
In this equation, the investment rate is equal to growth divided by ROIC:
Cash Flow
Earnings
Growth/ROIC
=
×
−
(
)
1
For Value Inc.:
$
$
(
%/
%)
$
(
%)
75
100
1
5
20
100
1
25
=
×
−
=
×
−
For Volume Inc.:
$
$
(
%/
%)
$
(
%)
50
100
1
5
10
100
1
50
=
×
−
=
×
−
Since the three variables are tied together mathematically, you can describe 
a company’s performance with any two variables. We generally describe a 
company’s performance in terms of growth and ROIC because, as mentioned 
earlier, you can analyze growth and ROIC across time and versus peers.
3 We assumed that all of the increase in profits is due to the new investment, with the return on Value 
Inc.’s existing capital remaining unchanged.

32  Fundamental Principles of Value Creation
Exhibit 3.4 shows how different combinations of growth and ROIC gen-
erate different levels of cash flow that can be paid out to investors. The 
numbers in the boxes represent cash flow as a percentage of NOPAT, which 
represents the profits available for distribution to investors. You can see 
that as growth slows at any level of ROIC, the cash generated per dollar of 
NOPAT increases. That explains why even maturing companies experienc-
ing slowing growth can pay out much larger amounts of their earnings to 
investors. Note also that companies with high ROIC tend to generate lots of 
cash flow as long as they are growing modestly. This explains why mature 
tech and pharma companies with high returns on capital pay out so much 
of their earnings to investors. They don’t really have a choice, because they 
typically generate much more cash flow than they can reinvest at attractive 
returns on capital.
Note that near-term cash flow by itself may not be a meaningful perfor-
mance indicator. Consider what would happen if Value Inc. were to find 
more investment opportunities at a 25 percent ROIC and be able to increase 
its growth to 8 percent per year. Exhibit 3.5 shows the projected NOPAT 
and cash flow. Because it would be growing faster, Value Inc. would need 
to invest more of its earnings each year, so its cash flow at 8 percent growth 
would be lower than at 5 percent growth until year 9. However, its value, 
which at 5 percent growth would be $1.5 billion, would double at 8 per-
cent growth to $3 billion, because its cash flows would be higher in the 
long term.
EXHIBIT 3.4  Translating Growth and ROIC into Cash Flow Available for Distribution
% of NOPAT
7%
9%
13%
ROIC
3%
6%
9%
Growth
25%
–14
0
31
14
33
54
57
67
77
64
76
88

The Relationship of Growth, ROIC, and Cash Flow  33
If you simplify some assumptions—for example, that a company grows 
at a constant rate and maintains a constant ROIC—you can reduce the dis-
counted cash flow to a simple formula. We call this the value driver formula. 
Here, NOPAT represents the net operating profit after taxes, g is the growth 
rate of the company, and WACC is the cost of capital.
Value
NOPAT
ROIC
WACC
=
−




−
=
t
g
g
1 1
Using this equation, you can see that value is driven by growth, ROIC, 
and the cost of capital, just as we described in the example. In practice, 
we rarely use this formula by itself, because of its assumption of con-
stant growth and ROIC forever. Still, we find it useful as a reminder of 
the elements that drive value. Note that improving ROIC, for any level of 
growth, always increases value because it reduces the investment required 
for growth. The impact of growth, however, is ambiguous, as it appears in 
both the numerator and the denominator. In the next section, we’ll show 
that faster growth increases value only when a company’s ROIC is greater 
than its cost of capital. At the end of this chapter, we’ll also show how this 
equation is derived.
EXHIBIT 3.5  Value Inc.: Lower Initial Cash Flow at Higher Growth Rate
$ million
5% growth
Year 1 Year 2
Year 3
Year 4
Year 5 Year 6
Year 7
Year 8
Year 9
Year 10
Year 11
Year 12
NOPAT
100
105
110
116
122
128
138
141
148
155
163
171
Net investment
(25)
(26)
(28)
(29)
(30)
(32)
(34)
(35)
(37)
(39)
(41)
(43)
Cash flow
75
79
83
87
91
96
101
106
111
116
122
128
8% growth
Year 1 Year 2
Year 3
Year 4
Year 5 Year 6
Year 7
Year 8
Year 9
Year 10
Year 11
Year 12
NOPAT
100
108
117
126
136
147
159
171
185
200
216
233
Net investment
(40)
(43)
(47)
(50)
(54)
(59)
(63)
(69)
(74)
(80)
(86)
(93)
Cash flow
60
65
70
76
82
88
95
103
111
120
130
140
Higher growth rate initially generates less cash flow