How does compunding works with stocks?


I understand how compounding work with cash or money. Suppose, i have principle amount A with annual rate R. I will receive interest I=PR/100 in year and this interest will add on to my principle amount A and become A+I. So, now my priciple amount is larger hence my interest will be higher and so on.

As far as I know some stocks give dividends and some don’t. Now, for stocks without dividends, how does it work. People say just buy some stocks in ETFs and forget about it for years and it will compound. How? As far as I understand, I buy a share of 100 costing 10£ each. So, i spend 100×10£=10000£. Lets say the value of stock goes to 20£ in 10 years. Now, I have total stocks of 100×20£=2000£ so, I got 1000£ extra. So, where is compounding here? Unless, i sell it and buy other stocks. My stocks is not increasing. Only value of my stock is. How is it compounding?

In: 5

People normally think of growth as a percentage, kinda like actual loan interest. If you look at your gains year by year, you can describe any year as A+I. You just aren’t sure what R will be in any given year.

Year one A: $1000

Year two A+I: $1035

Year three A+I: $1100

Year 4: $1140

Year 5: $1300

Etc. I’m trying to show how the return rate changes as a percentage, but the value builds on the previous year even when the rate is slow.

And of course it must be said that stocks can also *lose* value by having a negative return for that period.

Dividends come out of growth so that’s not exactly related to your question. Taking dividends is like cashing out future growth, which is why most brokerage services off DRIP (Dividend Re-Investment Plan).

I’ll have a go at answering

The thing is good equities in strong companies, with competent management teams, insurmountable moats and high barriers to entry are great compounders. It’s just that they do the compounding for you – best way to observe this is by looking at great stocks like FAANG, Walmart etc all their graphs are parabolic and to the right OVER TIME.

What’s happening here is the mgmt team are increasing revenues, improving profit margins by investing in the business, making smart +EV decisions over time. What you hope from your stock is an increasing earnings per share in perpetuity which is in the hands of mgmt and the company as well as a higher multiple paid for earnings as determined by the market.

In terms of compounding though, again, all of it is done automatically for you IF you pick the right companies so choose wisely.