The reinvestment rate measures how much a firm is plowing back to generate future growth. So clearly the reinvestment rate matters for growth. How does the reinvestment rate correlate with growth and therefore with the value of a business? We explore how the reinvestment rate impacts the value of a business in DCF valuation in this article in the specific condition that the business is NOT profitable.
How does the reinvestment rate impact the value of a business in DCF valuation when the business is NOT profitable?
When the return-on-investment is positive, increasing the reinvestment rate will cause the company to grow at a higher rate and increase the value of the business. The equation for sustainable growth = Retention ratio* Return on Equity. The reinvestment rate is only one part of the equation. The net result of the reinvestment rate also depends on the return-on-investment component. As long as the return-on-investment is positive, increasing the reinvestment rate will cause the company to grow at a higher rate and increase the value of the business.
Please note that the above holds true only when the business is profitable. Otherwise, this will not hold true!