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How does compounding work when you invest in the stock market?

It appears many people are not exactly clear about HOW compounding ACTUALLY WORKS when you invest. It is easy to see in terms of our bank deposits, where we are paid interest upon interest and it just goes on (although it is just a pittance these days!)

What about when you invest? When you invest in a company, how does that investment actually compound?

The key is understanding how effective the company (actually its management) is in DEPLOYING THE CAPITAL it has on hand. Obviously, this depends on whether management is capable and sensible in that decision making process. Crucially, it also depends on whether excellent REINVESTMENT OPPORTUNITIES are available.

If the company has $10m of capital (in the form of asset, cash, IP etc), then if they are able to make 15% return on that capital, that $10m becomes $11.5m. After 1 year, if they still make 15% return on that $11.5m, it now becomes $13.23m. And so on. To simplify, if the valuation ratio, eg PE, remains the same, then the share price will increase at the same rate, and that is how YOU as a shareholder, benefit from that compounding.

Just some food for thought. 🙂

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