The Power of Compounding

“Compound¬†interest is the eighth wonder of the world. He who understands it, earns it. he who doesn’t… pays it.” Albert Einstein

At the heart of it, I’m looking to invest in durable, high quality companies at attractive prices. However, it’s important to note that for long-term owners of businesses, quality will prove much more critical than price. This is due to the simple math behind compounding.

Allow us to illustrate with an example where we have the following companies:

  1. Re-investment Co. produces 25% ROIC and can reinvest 100% of its earnings. Currently earns $10/share and trades on a multiple of 20x
  2. Undervalued Co. produces 10% ROIC and can reinvest 25% of its earnings. Currently earns $10/share and trades on a multiple of 10x

If we assume a 10 year holding period and that at maturity both businesses will trade on a multiple of 15x, we get the following results.

Screen Shot 2018-05-11 at 2.21.47 pm

As you can see, despite Undervalued Co’s multiple increasing 50% and Re-investment Co’s multiple shrinking 25%, Re-investment Co is by far and away the superior investment option.

Examining the numbers it becomes clear that (1) the longer your investment horizon, the closer your return will be to returns of the underlying business, and (2) whilst the price paid matters, it’s often not as important as people think.

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