Plowback in the Constant‐Growth DCF Model

Abstract

Valuation experts have recommended using the finance formula equating real growth in net cash flows (g) to the plowback rate (k) times the real return on investment (r) as a more reasonable basis for estimating plowback in the steady‐state perpetuity period of the standard value‐driver DCF formula. Unfortunately, practitioners make two errors when estimating implied plowback as k = g ÷ r. The first error is to use the incorrect nominal formula k = G ÷ R that is still found in finance and valuation textbooks. The second error arises because there are two ways to define plowback in the value‐driver DCF model. The problematic traditional definition measures plowback ratio as a function of accounting NOPAT (before it has been transformed into cash NOPAT by deducting incremental working capital), thereby including in the numerator not only net new investment, but also changes in incremental working capital. The authors call this accounting plowback, and show why it is generally inappropriate to estimate implied accounting plowback using the formula k = g ÷ r. The authors explain in detail why the cash plowback presented in Bradley Jarrell (2008) is generally appropriate for estimating implied plowback and why accounting plowback is more problematic in this application.