Compound Interest: 8th Wonder of the World

Compound interest is such a powerful yet neglected idea, that Albert Einstein famously called it “the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” — Warren Buffet

What is compound interest?

Compound interest is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest.

Why Does Compound Interest Matter?

Over the long run, compounding is how your portfolio doubles/triples. It is one of the most powerful fundamental principles in finance. Compounding is basically used in almost every formula that discounts future events to the present and present events into the future. We use it almost everywhere when trying to predict the future.

How do you calculate it?

Value = [P (1 + i)n] — P

Where P = principle | i = interest | n = compounding periods

The Rule of 72

Rule of 72 is a great way to calculate how many years it will take w/ compound interest to double your money. Simply take 72 and divide it by the growth rate expected over the long run of a company.

For example, a company grows 15% a year. Rule of 72 states that your investment will double in 4.8 Years.

Dividend Aristocrats & Dividend Growth Investing

Companies that pay dividends are excellent candidates for leveraging compound interest over time when you do a dividend reinvestment plan (DRIP).

If you want to get in on this investment strategy I recommend you look up Dividend Aristocrats. These are companies that increase their dividend every year. Why does this matter? It actually supercharges your compounding interest strategy because the money being compounded is growing over time.

Valuing Companies with Compounding

Compound interest does not have to apply only to cash flows from a company. You can do the same math on earnings, revenues, operating income… Anything that is expected to grow at an average growth rate over time.