FINM3005 · Corporate Valuation
Growth and Terminal Value
Every forecast has a growth rate baked into it, and the temptation is to treat a higher g as automatically good news. This chapter is the systematic refutation of that instinct: growth is not value — the spread is. Growth consumes capital, and capital has a cost, so growth creates value only when the return on the new capital it absorbs — the marginal return, RONIC — beats the WACC; below that hurdle, faster growth destroys value. You meet the growth identity g = reinvestment rate × ROIC and its punchline FCF = NOPLAT(1 − g/ROIC), so that for a given growth rate a higher-ROIC firm reinvests less and throws off more cash. The NPV-of-growth rule (value created ⇔ RONIC > WACC) falls straight out of the key-value-driver terminal-value formula. The chapter also ranks the value-of-growth ladder (new markets at the top, large acquisitions at the bottom, where the premium leaks to the seller), explains competitive fade and why the convergence terminal value is the default, and shows how to capitalise R&D. This is the same RONIC-vs-WACC logic that governs the terminal value, so the two ideas — growth and continuing value — belong together.
What this chapter covers
- 01Organic vs inorganic growth — same valuation test for both
- 02The value-driver tree: margin × turnover → ROIC, reinvestment × ROIC → g
- 03The growth identity and FCF = NOPLAT(1 − g/ROIC)
- 04RONIC vs WACC: the NPV-of-growth rule
- 05The value-of-growth ladder: not all growth is equal
- 06Competitive fade and why convergence is the default terminal value
- 07Capitalising R&D for research-intensive firms
Worked example: is the expansion value-accretive?
- +1Existing business. ROIC = 200 / 1,250 = 16% > WACC 9% — it already creates value; the question is whether the expansion does.
- +1(a) Growth bought. Apply the identity to the new capital: g = IR × RONIC = 0.40 × 0.12 = 4.8% p.a.
- +1(b) The test. RONIC 12% > WACC 9% — spread +3pp — so each new dollar earns above its cost and growth creates value.
- +1Value, capitalised. Using the key-value driver: 200(1 − 0.048/0.12) / (0.09 − 0.048) = 120 / 0.042 ≈ $2,857m, above the no-growth value 200/0.09 ≈ $2,222m — growth added ~$635m.
- +1(c) RONIC = 7%. To still grow at 4.8% the firm must reinvest IR = 0.048/0.07 = 68.6% — nearly double the capital for the same growth.
- +1Verdict flips. Value = 200(1 − 0.686) / 0.042 = 62.8 / 0.042 ≈ $1,495m — below the no-growth $2,222m. Same 4.8% growth, but it destroyed ~$727m. The only thing that changed was RONIC crossing the WACC line.
Key terms
- RONIC
- Return on new invested capital — the marginal return on the capital that growth actually absorbs, not the firm's historical average ROIC. Growth creates value if and only if RONIC > WACC; equal is value-neutral; below is value-destroying. A firm with a glorious average ROIC can still destroy value by expanding at a low marginal RONIC.
- The growth identity
- g = reinvestment rate × ROIC, equivalently IR = g/ROIC, with FCF = NOPLAT(1 − g/ROIC). It says you cannot grow operating profit without reinvesting cash, and that for a given growth rate a higher-ROIC firm reinvests less and keeps more free cash — 'Value Inc. vs Volume Inc.'.
- NPV-of-growth rule
- Growth creates value ⇔ RONIC > WACC. Each new dollar costs the WACC to raise and earns RONIC, so the value created per dollar is the capitalised spread (RONIC − WACC). The rule falls straight out of the key-value-driver terminal-value formula, where setting RONIC = WACC collapses it to the convergence value.
- Value-of-growth ladder
- Growth types ranked by value created per dollar of revenue: new products creating new markets at the top, then selling more to existing customers and attracting new ones, down to promotional share gains and large acquisitions at the bottom — where a fat control premium leaks much of the value to the target's shareholders.
- Competitive fade
- The empirical decay of abnormal growth and returns: high-growth episodes rarely last beyond five years, and abnormal ROIC mean-reverts toward the WACC as competition arrives. Models build fade in explicitly, which is why the convergence terminal value (CV = NOPLAT/WACC, baking in RONIC → WACC) is the default.
Growth and Terminal Value FAQ
Why isn't faster growth always good?
Because growth consumes capital and capital has a cost. A company can grow revenue, earnings and even EPS while shrinking in value if the new capital earns below the cost of capital. The market eventually sees through growth that earns below the WACC. Never recommend a stock on its growth rate alone — always ask what the new capital earns relative to the WACC.
What's the difference between ROIC and RONIC, and which governs the growth decision?
ROIC is the return on the firm's existing invested capital (the historical average); RONIC is the return on the new capital that growth absorbs (the marginal return). The growth decision is governed by RONIC vs WACC, not average ROIC. A firm with a 25% historical ROIC can still destroy value by making an acquisition whose marginal RONIC is 7% against a 9% WACC — a trap examiners love to bait.
Why is convergence the default terminal-value method?
Because competition empirically drives the return on new capital down toward the cost of capital (RONIC → WACC), so growth adds no value beyond the explicit horizon. Setting RONIC = WACC in the key-value-driver formula collapses it exactly to CV = NOPLATₜ₊₁/WACC. Use the Gordon/key-value-driver form (which rewards a positive spread) only when you can justify continued excess returns with a real moat.
How do I treat R&D for a research-intensive firm?
Expensing R&D understates both earnings quality and invested capital. The Damodaran adjustment capitalises R&D as an asset amortised over its useful life: adjusted earnings = earnings + current R&D − amortisation of past R&D, and the unamortised research asset is added to book equity and invested capital. This gives a cleaner ROIC and a fairer picture of where value is being built.
Exam move
Anchor on one sentence — growth creates value only when RONIC > WACC — and let everything else hang off it. For any growth question, run the identity (g = IR × RONIC), compute the spread on the new capital (never the average ROIC), and capitalise it with the key-value-driver formula to show value created or destroyed. Practise the two-lane contrast (same g, RONIC above vs below the WACC) until the sign flip is automatic, because that is the exam's favourite bait. For terminal value, default to convergence and justify the Gordon form only with a real competitive advantage; remember the ladder (large acquisitions sit at the bottom) and fade hot growth toward sustainable rates. The economic layer matters as much as the arithmetic: a positive spread must come from a genuine moat, or competition will erase it.
