How do you know if your business growth rate is good or not? If your business is growing at 20%, how do you know if it’s a good growth rate or not? But wait, where did you get this 20% number from? From sales? Or from earnings? Or from cash flow? This is what this article is about. You’ll find out the correct way to calculate business growth rate. Also, you’ll learn how to evaluate if your business growth rate is good enough.

At the outset, you need to understand a few metrics. Don’t worry, these are simple ones.

Let’s say you start a tech startup with an initial investment of $100,000. Your put your own money of $80,000 and take a debt of $20,000.

In the first year:

• Revenue was $150,000
• Operating expenses (excluding interest): $110,000
• EBIT (Earning before interest and tax) OR (Operating Profit): $40,000
• Tax rate: 25%

NOPAT (Net Operating Profit After Tax)

NOPAT = EBIT x (1 – tax rate) = $40,000 x (1 – 0.25) = $30,000.

NOPAT is after-tax operating profit as if your business has no debt. Your operating profit should show a clear picture of how much profit your business generated from pure operations, irrespective of whether or not you took debt. Interest costs and the related tax benefit (interest costs are a tax-deductible expense) should not distort the true operating profit picture. Therefore, interest is excluded.

ROIC (Return on Invested Capital)

ROIC = NOPAT / Invested Capital = $30,000 / $100,000 = 30%

ROIC shows the percentage return your business earns on the capital invested. Of course, the higher, the better. Here, ROIC of 30% means your business generated a return of $30 on every $100 invested.

Note that while NOPAT excludes the impact of debt, Invested Capital in ROIC includes debt because capital is capital. The source of financing doesn’t change the amount of capital.

WACC (Weighted Average Cost of Capital)

WACC = (Equity/Capital) x Cost of Equity + (Debt/Capital) x Cost of Debt x (1 – tax rate) = [(80,000/100,000) x 12%] + [(20,000/100,000) x 6% x (1 – 0.25)] = 10.50%

WACC is nothing but the cost of equity and the cost of debt, weighted by their share in the capital structure.

The cost of equity is the minimum rate of return you expect from your investment in your business. Let’s say you can earn 12% by investing in index funds or stock markets. This 12% is the minimum required return you expect from your business, or else why would you take the risk of starting or running a business. So, from your business point of view, this 12% is the cost of equity – the minimum rate the business is expected to pay you for using your money.

The cost of debt is simple to understand. It’s nothing but the rate of interest the lender charges for lending money to your business. Here, it’s 6%. But since interest cost is a tax-deductible expense (lowering your business’s taxable income), the effective rate of interest is 6% minus the tax rate. So, it’s effectively 4.50%.

So, WACC is actually the average cost at which your business has taken capital from you and the lenders. Your business must generate a return that covers the WACC, i.e. 10.50%.

Compare ROIC with WACC

• ROIC = 30%
• WACC = 10.50%

Since ROIC is greater than WACC, your business is generating value for you. Every $100 invested earns $30 while you and the lender only demand $10.50.

Growth rate

Let’s say you plan to reinvest 50% of NOPAT into your business for the next year and draw the remaining 50%. In other words, $15,000 to be reinvested into the business and the balance $15,000 to be drawn or to be held as free cash.

So, the growth rate here will be: Reinvestment rate x ROIC = 50% x 30% = 15%.

Note that when we say growth rate, we mean growth in NOPAT.

IMPORTANT

Is 15% growth rate good? Yes, because ROIC is more than WACC. The rate of growth doesn’t matter. What really matters is if ROIC is more than WACC or not.

Now, assume a scenario where ROIC is less than WACC. That means the business isn’t generating enough return to meet its cost of capital.

Let’s say the ROIC, in this example, is 8% instead of 30%. What happens? With 50% reinvestment plan, the growth rate will be: 50% x 8% = 4%. Let’s say, you instead decide to reinvest 100% instead of 50%, the growth rate still will be only: 100% x 8% = 8%. Makes sense?

To get a growth rate of 15% with a ROIC of 8%, you’ll need to reinvest 15%/8% = 187%. So, theoritically it means you need to put additional money into your business to achieve that 15% growth rate.

Did you notice another important thing here? The higher the ROIC (above WACC), the lower the reinvestment required to keep up with a desired growth rate.

Let’s say the ROIC, in this example, is 40% instead of 30%. What happens? To maintain a growth rate of 15%, you need to invest just 15%/40% = 37.50% of NOPAT next year.

Summing up

A good growth rate is subjective if you look at it in isolation. A 15% growth rate might sound impressive, but whether it’s truly good depends entirely on the relationship between ROIC and WACC:

• If ROIC > WACC = Growth is value-creating. Even moderate growth rates are good because reinvested capital earns more than its costs.
• If ROIC < WACC = Growth is value-destroying. Even high growth rates are bad because reinvested capital earns less than its costs.

In this example, your business growth rate of 15% is good because the ROIC (30%) is well above the WACC (15%). If the ROIC is lower than WACC, the 15% growth rate target will become unrealistic.