We can use the link between value, growth, risk, and returns to rethink how we calculate a company's terminal value. The standard terminal value formula uses the Gordon growth formula, and that tells us that terminal value is equal to the free cash flow in the final forecast year, multiplied by one plus the growth rate divided by the cost of capital, less the growth rate. But we know that free cash flow is equal to NOPAT less net reinvestment in the business where net reinvestment is equal to the Dollar increase in invested capital. In turn, if growth is constant, which it must be in the terminal phase, net reinvestment in the business is equal to the growth rate multiplied by invested capital. If we replace free cash flow in the terminal value formula with NOPAT, less the growth rate times by invested capital, but also then rearrange to allow for the fact that return on invested capital is NOPAT divided by invested capital, we have a new terminal value formula.

Terminal value in the final forecast year is equal to NOPAT in the final forecast year, multiplied by one minus the growth rate divided by return on invested capital multiplied by one plus the growth rate, all divided by the cost of capital, less the growth rate.

Now, although that sounds like a pretty scary formula, this new way of writing terminal value is actually incredibly powerful. It's referred to as the value driver formula, as it expresses terminal value using the drivers of value, growth, risk, and returns. Effectively, this formula forces the implied free cash flow in the final forecast year to reflect not just our growth expectations, but also the reinvestment needed to support that growth.

In fact, one of the terms in this formula growth divided by return on invested capital is often referred to as the reinvestment rate, as it reflects the proportion of NOPAT that needs to be reinvested to support growth. For example, if a company is expected to grow at 5% and is generating a return on invested capital of 10%, well this implies that the company needs to reinvest 50% of its profits each year to support that growth. Which in turn means that 50% of profits are free to be returned to investors as free cash flow.

Conversely, a company which is expected to grow at 5%, but is generating a return on invested capital of 20% needs to reinvest just 25% of its profits each year to support that growth, which in turn means that 75% of its profits are free cash flow.

Intuitively, this agrees with our understanding of valuation. Companies which generate a higher return on capital, will have a higher valuation, even if it has the same growth rate as peers. This is because the higher return on capital means that companies generate a higher free cash flow and can return their cash to investors much more quickly.