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Growth creates value only when it out-earns the cost of capital

At the same 5 percent growth, the company earning 15 percent on reinvested capital is worth four times the one earning 6 percent.

7 min read2026-08-10

Why this matters

Every company that reinvests its profit is making a bet that the money it puts back in will earn more than it costs. Markets reward companies that grow fast and mark down those that grow slowly, yet the growth rate on its own says nothing about whether the reinvestment behind it is a good bet. This lesson shows when growth adds value and when it takes value away, using one formula and two companies you can check on a calculator. By the end you will be able to look at a growing company and ask the single question that settles whether its growth is worth anything. Does the capital it reinvests earn more than that capital costs?

Background optional reading
01
Costco turns each invested dollar into 37 cents of profit: what return on capital measures, and why it is the return the reinvestment must beat.
02
A chipmaker's cost of capital runs more than double a utility's: the return investors require, which sets the hurdle this lesson turns on.
03
A dollar next year is worth 95 cents today: how a stream of future cash collapses into one value today, the arithmetic under the formula below.

Growth has a price

A company cannot grow its operating profit by wishing for it. To sell more next year it has to build, hire, or buy more, and all of that takes capital the company puts back into the business instead of handing to its owners. The size of the growth is fixed by two numbers: the share of profit the company reinvests, and the return that reinvested capital earns. Growth in operating profit equals the reinvestment rate times the return on capital.1

g = \text{Reinvestment rate} \times \text{Return on capital}

Written this way, growth is never free. A higher growth rate demands either a larger slice of profit reinvested or a higher return on what is reinvested, and the reinvested profit is money the owners do not receive. That is why the familiar advice, that growth is good and more growth is better, is at most half a rule. Damodaran files it under myths for a precise reason: because growth has to be paid for, a company can pay more for it than the growth is worth.2 Whether the purchase adds value or subtracts it turns on one comparison: the return the new capital earns set against what that capital costs.

The return on that capital sets the value

The comparison has a formula behind it. For a business whose profit grows at a steady rate forever, its value today can be written from just four numbers, each named under the equation below.3

V = \htmlClass{nb-mc1}{\mathrm{NOPLAT}_{1}} \cdot \dfrac{1 - \dfrac{\htmlClass{nb-mc2}{g}}{\htmlClass{nb-mc3}{\mathrm{RONIC}}}}{\htmlClass{nb-mc4}{\mathrm{WACC}} - \htmlClass{nb-mc2}{g}}
  • \mathrm{NOPLAT}_{1}next year's operating profit after tax, before any growth is paid for.
  • gthe yearly growth rate of that operating profit.
  • \mathrm{RONIC}the return on newly invested capital: what each reinvested dollar earns.
  • \mathrm{WACC}the cost of capital, the return investors could earn elsewhere at the same risk.
The value of a business whose profit grows at a constant rate, from four inputs. Whether more growth raises or lowers that value depends on the return on new capital against the cost of capital.3

Watch what happens at one particular value of the return on new capital: set it equal to the cost of capital. The numerator becomes one minus g over the cost of capital. Dividing that by the cost of capital minus g leaves next year's profit over the cost of capital. The growth rate has cancelled out. The company is worth exactly what it would be worth with no growth at all, because a business that reinvests nothing is also worth its profit divided by its cost of capital. When the new capital earns precisely what it costs, growth moves the value not at all.3

That is the pivot. Above it, when the return on new capital clears the cost of capital, more growth raises the value. Below it, when the return falls short of the cost of capital, more growth lowers the value. A company can be growing and posting real profits and still be destroying value the whole time, if the return it earns on capital sits below what that capital costs.4

At one growth rate, the values pull apart

Hold everything fixed except the return on new capital. Two companies each expect 100 dollars of operating profit after tax next year. Each reinvests enough to grow that profit 5 percent a year, and each faces a 9 percent cost of capital. The one difference is what their reinvestment earns: the first company earns 15 percent on it, the second earns 6 percent.

Put the first company's numbers into the formula. One minus 0.05 over 0.15 is about 0.667. Divide that by 0.09 minus 0.05, which is 0.04, then multiply by the 100 dollars of profit. The value comes to about 1,667 dollars. Now strip the growth out. With no growth there is no new capital, so the return on new capital never enters. Each company is then worth its profit over its cost of capital: 100 divided by 0.09, or about 1,111 dollars. The first company's growth lifted its value from 1,111 to 1,667, adding roughly 556 dollars.3

The second company grows at the very same 5 percent, and it is worth about 417 dollars: well under the 1,111 it would fetch standing still. Its growth did not add value. It destroyed almost 700 dollars of it. The two businesses grow at an identical rate and start from an identical profit, and the one earning 15 percent on its reinvestment is worth close to four times the one earning 6 percent.

Two companies with the same next-year profit ($100), the same 5% growth, and the same 9% cost of capital, valued with the growth and again with none.3
Company Return on new capital Value with no growth Value at 5% growth What growth did
Firm A 15% $1 111 $1 667 +$556
Firm B 6% $1 111 $417 −$694

Returns do not stay above the cost of capital

The clean split between value created and value destroyed lives inside a set of assumptions worth naming. The formula assumes one growth rate held to perpetuity and a steady return on new capital, with growth below the cost of capital so the value stays finite. The return it tests is the return on the next dollar reinvested, the marginal dollar, not the average return on all the capital the company already holds.3

The rule's scope

Growth changes from adding value to subtracting it as the return on newly reinvested capital crosses the cost of capital, within a constant-growth valuation. It is a claim about the marginal reinvested dollar, not a verdict on a firm's average historical return and not a promise that any return holds forever.2

Real returns do not hold forever. High returns on capital are more durable than high growth, but competition still pulls them down toward the cost of capital as rivals arrive. A company already earning below its cost of capital usually cannot fund much growth in the first place. Capital is hard to raise for a business that does not clear its cost. Among low-return United States firms in 1995, nearly a third were acquired or had gone bankrupt within ten years.5

Where a company should push therefore depends on where its return already sits. When the return on capital is high, growth tends to add value and is worth chasing; when the return is low, raising the return creates more value than growth does.6 The evidence backs the ordering. Over a decade, companies that raised their return on capital earned 5 to 8 percentage points more in annual return to shareholders than companies that did not. Beating the market on growth was worth only 1 to 4.5 For a company earning below its cost of capital, growth piled on before the return is fixed only deepens the hole.

The takeaway

Growth is neither free nor automatically good. A company buys growth by reinvesting capital, and that purchase adds value only when the new capital earns more than it costs. Two companies growing at the same rate can be worth wildly different amounts. The one earning 15 percent on its reinvestment was worth close to four times the one earning 6 percent, and the second was worth less growing than it would have been standing still. The clean rule holds on the next dollar reinvested and inside a steady-growth model; in the real world returns fade as competitors arrive, and a company earning below its cost of capital often cannot fund growth at all. So when you meet a fast-growing company, the question is never how fast it grows. It is whether the capital behind that growth earns more than that capital costs.

Go deeper optional reading
01
Aswath Damodaran, "Myth 5.3: Growth is good, more growth is better!": the full argument with his own sensitivity table showing value fall, hold, and rise as the return crosses the cost of capital.
02
Bin Jiang and Timothy Koller, "How to choose between growth and ROIC": the empirical study behind the fade, tracking United States firms from 1995 to 2005.

Sources

  1. NYU Stern (Aswath Damodaran) · The Fundamental Determinants of Growth
  2. Musings on Markets (Aswath Damodaran) · Myth 5.3: Growth is good, more growth is better!
  3. Koller, Goedhart & Wessels (McKinsey / Wiley) · Valuation, 5th ed., Appendix A
  4. McKinsey · How are companies valued?
  5. McKinsey Quarterly (Jiang & Koller) · How to choose between growth and ROIC
  6. McKinsey on Finance (Cao & Jiang) · Balancing ROIC and growth to build value