Tao of Corporate Finance

The value formula from Valuation: Measuring and Managing the Value of Companies by McKinsey & Company (also referred to as the Tao of Corporate Finance) is:

Where:

• NOPAT = Net Operating Profit After Taxes (proxy for cash earnings)
• ROIC = Return on Invested Capital (measures profitability of invested capital)
• WACC = Weighted Average Cost of Capital (cost of funding the business)
• g = Growth rate of NOPAT

At first glance, it looks like just another finance formula. It is not.
This one quietly tells you almost everything that matters: profitability, reinvestment, growth, and capital discipline. Not bad for one line.

Tao of Corporate Finance Comes from the Standard Value Formula

This formula comes from the standard perpetuity value formula:

Where:

• FCF₁ = Free Cash Flow in the first year after the valuation date
• WACC = Weighted Average Cost of Capital
• g = Perpetual growth rate of FCF

Then free cash flow is linked to operating economics through:

Where:

• NOPAT = Net Operating Profit After Taxes
• ROIC = Return on Invested Capital
• g / ROIC = Reinvestment rate required to sustain growth

So the Tao formula is simply the standard perpetuity formula after replacing FCF with its real operating driver: profit, reinvestment, and return on capital.

In other words, free cash flow does not fall from the sky. Management has to earn it.

Growth vs ROIC

Interpretation:

• If ROIC > g, the company generates excess cash.
• If ROIC < g, the company consumes cash to sustain growth.

This is one of the most useful filters in investing. Growth sounds exciting, but growth by itself is not a strategy. Cancer also grows.

The real question is whether growth requires too much capital, and what return that capital earns. That is where management quality starts to show. Strong managers do not just grow — they grow while keeping reinvestment efficient.

ROIC vs WACC

For a perpetuity case where economic profit grows at a constant rate g, the formula simplifies to:

Where:

Interpretation:

• If ROIC > WACC, the company creates value.
• If ROIC = WACC, the company’s value is simply its invested capital.
• If ROIC < WACC, the company destroys value over time.

This is where management strength becomes visible in economic terms.

A weak management team can grow revenue, tell a good story, and still destroy value.
A strong management team allocates capital well, protects returns, and earns more than the cost of capital. That is the difference between building a business and just making it bigger.

P.S.

This formula is powerful, but it should not be used too mechanically.

• Valuation is often multi-stage, not one-stage.
  In practice, DCF models are usually built in two or three stages, with different growth rates over time. A single perpetual g is only a simplification.
• ROIC is less useful for asset-light businesses.
  If a business is not capital-intensive, ROIC can be unstable or less meaningful, because invested capital may be too small relative to earnings.
• Reported ROIC is not the same as economic ROIC.
  To calculate ROIC properly, financial statements often need to be reorganized and adjusted. Reported numbers can look clean while saying very little.

Source:

Valuation, Measuring and Managing the Value of Companies – by McK.&Co, T. Koller, M. Goedhart, D. Wessels