Businessman Investor

Touching base with the rational business psyche of stock market investors

Sunday, August 14, 2011

Compounding Power of Stocks

Money begets money. The compounding power of stocks can be observed in its underlying business' return on equity (ROE). Like an interest rate in a bank, the higher it is, the more the business proportionally generates wealth to the shareholder. As an investor, what you're after are businesses able to maintain the highest, consistent ROE's spanning years and decades.
As a lot of fellow long-term investors are enthusiastic about the compounding advantages of buying and holding for the long haul, I began to contemplate where this compounding power is derived. Most would try to express this magical stock attribute in market terms—they’d pick a stock which has performed considerably well and then easily point out the stock’s market price in two points in time (e.g. had you bought some shares of Company A at a certain price a decade ago, held on to it up to this day, with its stock now trading at this price, your holding should now be worth twice or more, compounding money at a rate above 15%). While it concretely presents the effect of compounding, it’s too bias on the market (i.e. stock price), and tells you nothing of the economic merits of the stock as a true, performing business. After all, the compounding power of stocks is found not in its stock price, but in its underlying business.

Hence, the yardstick I personally prefer to gauge this compounding power is the business’ return on equity (ROE). ROE, computed as net income/ average shareholder’s equity, is a straight forward measure of the firm’s profitability. It explicitly asks and answers the question: how much earnings did the business produce relative to its capital? Intuitively, it’s like the interest rate of a bank placement. Had you deposited, say, Php 1M in a special time deposit account and it earned Php 100K, then your placement’s interest rate is 10%. In the same way, had you set up a business with Php 1M worth of capital and it came up with Php 100K in annual earnings, its ROE is 10%. Of course, getting a 10% interest rate from a bank placement deposit is very rare, if not far from reality. But a business earning 10% in a year? How about 30%? I dare say: such businesses exist!

Why divide net income by average shareholder’s equity? This is the average of equity in the beginning and ending of the year. Using the average shall consider any capital infused into the business (e.g. initial public offerings, or secondary offerings), say, in the middle of the year, and be able to subject them to the same efficiency test. Further, it considers any reductions from equity (e.g. share buybacks, cash dividends issued, etc.) and likewise reward businesses able to produce the same level of earnings with lesser capital. Using the average shall give a closer-to-reality, more conservative rate of return. As an investor, anyway, you should only expect that with additional capital, the business should proportionately yield more earnings—if not, then it is not fully making use of capital (had been better had there been no additional infusions at all).

So how does the compounding effect work? It works like magic. The capitalist's expectation on any investment is that it should be able to provide more profits from more capital. Each additional earnings gained by a business, had it been retained, becomes part of the business’ equity—thus, it should only provide more earnings in return. It’s like interest earning on interest. This is the compounding power of a stock—rooted in the underlying business’ profitability (i.e. capacity to deliver more profits from more capital). The longer you hold on to it, the sweeter it gets, and the richer you become.

2 comments:

  1. Nice posts! Gonna come back here a lot more often. I like how you explain financial concepts in easy to understand terms. I'm a blogger myself, (pilifinance.blogspot.com). I have a sibling in finance, but I'm just interested in it.

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  2. Speaking of compounding in stocks, I'm sure you've heard of Canadian author Derek Foster's book the Lazy Investor.. Dividend Reinvestment Plans.. There's that in US and Canada. Featured in my blog as well, (http://pilifinance.blogspot.com/2013/12/the-miracle-of-dividend-reinvestment.html)

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The information presented here is for educational purposes only. Under no circumstances should it be construed as a recommendation to buy, sell, or hold any stocks. If you choose to use this information, you do so at your own risk.

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