Once we understand the link between free cash flow growth and returns, we can link this to valuation. Let's start with our Gordon Growth formula. However, you'll notice here we are using it to calculate enterprise value rather than terminal value. We're therefore just assuming that this is a company which is growing at a constant rate from next year. So effectively, the company is already in its terminal phase, so that means that enterprise value is equal to next year's free cash flow divided by the cost of capital that's WACC, less the expected growth rate, which is G.

However, from our relationship between free cashflow and NOPAT, free cash flow is what's left over after reinvesting in the business. So free cash flow equals NOPAT, less net reinvestment in the business. We also know that net reinvestment in the business is the Dollar increase in the company's invested capital base, which is the same as the rate of business growth multiplied by the opening invested capital. Remember that if a company wants to grow its capital base and earnings at 6% and has 1000 of invested capital, it needs to reinvest 6% times by 1000 in the business, which is $60. If the company is growing at a constant rate, then this new capital will generate the same return as the existing capital. So earnings will also grow at 6%.

If we replace free cash flow in our Gordon Growth formula with NOPAT, less the growth rate times by invested capital. And remember that return on invested capital is equal to NOPAT, divided by invested capital. We can rearrange the standard Gordon Growth formula with a new version. This version links NOPAT, growth and return on invested capital. This formula allows us to see much more clearly what drives a company's valuation. If growth increases, then both the numerator and the denominator contract, but if the cost of capital is greater than return on invested capital, then the denominator will contract by more than the numerator, which will increase the company's valuation. If risk or cost of capital decreases, then the denominator contracts, so again, this will increase the company's valuation. If return on invested capital increases, then the numerator increases, so this will increase the company's valuation again. Growth, risk and returns are often referred to as value drivers as any increase in a company's valuation is a function of one or more changes in these items.

We can even go a step further. If we divide this formula by NOPAT, we effectively have a multiple on the left hand side that's EV divided by NOPAT. The value drivers on the right hand side have the same effect on multiples as on company valuation.