
Discounted Cash Flow Valuation  The Effect Of Compounding
Compounding is the ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.
Suppose you invest $10,000 into Cory's Tequila Company (ticker: CTC). The first year, the shares rises 20%. Your investment is now worth $12,000. Based on good performance, you hold the stock. In Year 2, the shares appreciate another 20%. Therefore, your $12,000 grows to $14,400. Rather than your shares appreciating an additional $2,000 (20%) like they did in the first year, they appreciate an additional $2,400, because the $2,000 you gained in the first year grew by 20% too.
If you extrapolate the process out, the numbers can start to get very big as your previous earnings start to provide returns. In fact, $10,000 invested at 20% annually for25 years would grow to nearly $1,000,000  and that's without adding any money to the investment!
Interest is often compounded monthly, quarterly, semiannually or annually. With continuous compounding, any interest earned immediately begins earning interest on itself. Albert Einstein allegedly called compound interest "the greatest mathematical discovery of all time." We think this is true partly because, unlike the trigonometry or calculus you studied back in high school, compounding can be applied to everyday life.
The wonder of compounding (sometimes called "compound interest") transforms your working money into a highly powerful incomegenerating tool. Compounding is the process of generating earnings on an asset's reinvested earnings. To work, it requires two things: the reinvestment of earnings and time. The more time you give your investments, the more you are able to accelerate the income potential of your original investment.
To demonstrate, let's look at another example:
If you invest $10,000 today at 6%, you will have $10,600 in one year ($10,000 x 1.06). Now let's say that rather than withdraw the $600 gained from interest, you keep it in there for another year. If you continue to earn the same rate of 6%, your investment will grow to $11,236.00 ($10,600 x 1.06) by the end of the second year.
Because you reinvested that $600, it works together with the original investment, earning you $636, which is $36 more than the previous year. This little bit extra may seem like peanuts now, but let's not forget that you didn't have to lift a finger to earn that $36. More importantly, this $36 also has the capacity to earn interest. After the next year, your investment will be worth $11,910.16 ($11,236 x 1.06). This time you earned $674.16, which is $74.16 more interest than the first year. This increase in the amount made each year is compounding in action: interest earning interest on interest and so on. This will continue as long as you keep reinvesting and earning interest.
Starting Early
Consider two individuals; we'll name them Pam and Sam. Pam and Sam are the same age. When Pam was 25 she invested $15,000 at an interest rate of 5.5%. For simplicity, let's assume the interest was compounded annually. By the time Pam reaches 50, she will have $57,200.89 ($15,000 x [1.055^25]) in her bank account.
Pam's friend, Sam, did not start investing until he reached age 35. At that time, he invested $15,000 at the same interest rate of 5.5% compounded annually. By the time Sam reaches age 50, he will have $33,487.15 ($15,000 x [1.055^15]) in his bank account.
What happened? Both Pam and Sam are 50 years old, but Pam has $23,713.74 ($57,200.89  $33,487.15) more in her savings account than Sam, even though he invested the same amount of money. By giving her investment more time to grow, Pam earned a total of $42,200.89 in interest and Sam earned only $18,487.15.
The following chart shows Pam and Sam's earnings:
You can see that both investments start to grow slowly and then accelerate, as reflected in the increase in the curves' steepness. Pam's line becomes steeper as she nears her 50s not simply because she has accumulated more interest, but because this accumulated interest is itself accruing more interest.
Pam's line gets even steeper (her rate of return increases) in another 10 years. At age 60 she would have nearly $100,000 in her bank account, while Sam would only have around $60,000  a $40,000 difference!
The effect of compound interest depends on frequency. Assume an annual interest rate of 12%. If we start the year with $100 and compound only once, at the end of the year, the principal grows to $112 ($100 x 1.12 = $112). If we instead compound each month at 1%, we end up with more than $112 at the end of the year. Specifically, we end up with $100 x 1.01^12 at $112.68. The final amount is higher because the interest compounded more frequently.
Compounding amplifies the growth of your working money and maximizes the earning potential of your investments  but remember, because time and reinvesting make compounding work, you must keep your hands off the principal and earned interest. (For related reading, see Overcoming Compounding's Dark Side. For a more advanced discussion of compound interest, read Accelerating Returns With Continuous Compounding.


Term
How Market Segments Work
A market segment is a group of people who share similar qualities. 
Active Trading
Market Efficiency Basics
Market efficiency theory states that a stock’s price will fully reflect all available and relevant information at any given time. 
Professionals
Is A Stockbroker Career For You?
Becoming a stockbroker requires a broad skill set and the willingness to put in long hours. But the rewards can be enormous. 
Economics
Understanding CostVolume Profit Analysis
Business managers use costvolume profit analysis to gauge the profitability of their company’s products or services. 
Fundamental Analysis
5 MustHave Metrics For Value Investors
Focusing on certain fundamental metrics is the best way for value investors to cash in gains. Here are the most important metrics to know. 
Fundamental Analysis
5 Basic Financial Ratios And What They Reveal
Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know. 
Investing
What Investors Need to Know About Returns in 2016
Last year wasn’t a great one for investors seeking solid returns, so here are three things we believe all investors need to know about returns in 2016. 
Investing Basics
How to Analyze a Company's Inventory
Discover how to analyze a company's inventory by understanding different types of inventory and doing a quantitative and qualitative assessment of inventory. 
Professionals
A Day In The Life Of A Public Accountant
Here's an inside look at the workdays of two experienced CPAs, to give you an idea of what it might be like to pursue a career as a public accountant. 
Professionals
A Day in the Life of a Public Accountant
There’s no typical day in the life of a public accountant, but one accountant’s experience may shed some light on what the career entails.

Tight Monetary Policy
A course of action undertaken by the Federal Reserve to constrict ... 
Laissez Faire
An economic theory from the 18th century that is strongly opposed ... 
ShortTerm Debt
An account shown in the current liabilities portion of a company's ... 
Audit
An unbiased examination and evaluation of the financial statements ... 
Sortino Ratio
A modification of the Sharpe ratio that differentiates harmful ... 
Climate Finance
Climate finance is a finance channel by which developed economies ...

What should I study in school to prepare for a career in corporate finance?
Depending on which area you want to specialize in, corporate finance can be one of the most competitive fields in business. ... Read Full Answer >> 
Why would a company issue preference shares instead of common shares?
Preference shares, or preferred stock, act as a hybrid between common shares and bond issues. As with any produced good or ... Read Full Answer >> 
What is the difference between cost of debt capital and cost of equity?
In corporate finance, capital – the money a business uses to fund operations – comes from two sources: debt and equity. While ... Read Full Answer >> 
What is the difference between gross profit, operating profit and net income?
The terms profit and income are often used interchangeably in daytoday life. In corporate finance, however, these terms ... Read Full Answer >> 
What is finance?
"Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >> 
What is the difference between positive and normative economics?
Positive economics is objective and fact based, while normative economics is subjective and value based. Positive economic ... Read Full Answer >>