The Power of Compounding


The Power of Compounding

Compound interest (or compounding of earnings) is simply the ability of interest (or investment return) earned on a sum of money to earn additional interest (or investment return), thereby increasing the return to the owner of the money or investor. It works like this and we will use interest as the exemplar:

You deposit a sum of money, say $1,000, in a bank or other financial institution that earns interest at the rate of 5 per cent, payable annually. At the end of the first year, you have earned $50 and have the right to get your $1,000 back.

Suppose however that you want to invest the money long-term, for say 10 years. You now have two options.

Option A: Take interest payments

You can have the interest paid to each year, in which case you will receive $50 each year to spend or use as you wish. At the end of the 10-year period, you will get your final interest payment and your $1,000 back.

Option B: Re-invest interest

You can choose to re-invest your interest and earn interest each year on the accumulated interest payments as well as on the original investment. This means that you do not get annual payments but, at the end of the 10-year period, you will get a lump sum payment of $1625. This is compound interest.

Why this much larger amount? Because your interest earns interest each year like this (calculations rounded to nearest 50 cents).

Year Principal sum Interest earned New principal sum
1 1000 50 1050
2 1050 52.50 1102.50
3 1102.50 55.00 1157.50
4 1157.50 58 1215.50
5 1212.50 61 1273.50
6 1273.50 64 1337.50
7 1337.50 67 1404.50
8 1404.50 70 1474.50
9 1474.50 74 1548.50
10 1548.50 77 1625

 

The higher the interest, the bigger the capital gain. At 10 per cent, the sum would increase to $2594.00; at 15 per cent, to $4055.00.

Compounding and retained earnings

A strong test of a company is its use of its retained earnings. If a company can earn more on the money it retains then it should use it, if it can not it should return it to the shareholder. This ignores taxation but is the simple truth in investment. If a company can continue to grow and earn a satisfactory rate on investment it should and if it has too much it should return it.

Put simply, if a company can retain earnings to grow shareholder wealth at better than the market rates available to shareholders, it should do so. If it can’t, it should pay the earnings to shareholders and let them do with them what they wish.

High returns on equity

The key to finding companies that can use your money efficiently is to look for companies with high returns on equity.

A powerful force

When asked to nominate the most powerful force on earth, Albert Einstein is reputed to have answered ‘compound interest’. Buffett might well agree.

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