More Info On Compounding Profits
Most people know that the sharemarket is a vehicle for growing your wealth but we also know that not all shares grow
. So what is it that differentiates the dogs from the pack leaders?
The power of investing in companies in the sharemarket is the power of compounding which you do not get to the same extent with any other investment.
I've talked about compounding before so now I want to take you through the steps on how to choose a company that applies compounding to its profits.
Compounding profits
Let's take for example JB HiFi (JBH). This is a company that has seen its share price soar to new heights.
But the real beauty of JB HiFi is when the power of compounding is applied to the profits that it makes.
In its last result, the company made 88c per share. The company gives 50% of what it makes as a dividend and then keeps 50% as retained earnings. That means 44c is paid as a dividend and 44c is reinvested back into the business.
The great thing is that because the company is able to provide such a strong return on investment, the 44c it reinvests can make another 18c.
How did I figure that out?
I simply took the return on equity rate of 42% (which you can find under 'Historical Financials' for JBH and applied it to the retained earnings of 44c (ie 42% of 44c) which is 18c.
That means just by keeping growth rates the same, in the next year, JB HiFi would make 88c+18c = $1.06.
And so it becomes a never-ending cycle of gains as long as growth rates remain stable.
Compounding power
You don't get the power of compounding to this extent from fixed interest securities or property.
While property will give you rents which can be likened to dividends, in terms of the capital in the house, it may go up in price but it will not compound. That is you will not see returns on your returns, thus multiplying your investment power.
The power of compounding is that you get returns on your return and your investment ends up being like an ever growing snowball.
Warren Buffett is a huge advocate of compounding and the power of compounding through shares. That's why the latest book on Buffett is called 'The Snowball'.
The secret is that you need to pick companies which are using this power of compounding.
Finding the pack leader
In order to find these gems, you need to see at least three things.
1. Earnings
The company needs to be making a profit to utilise the power of compounding. That means that any company without earnings cannot use the power of compounding to grow.
2. Dividends
Next you need to look at what the company does with its dividends. You don't want to see the company pay out all of its profits as dividends. This would signal that the company isn't interested in growing and will give you back a dividend because it perhaps feels that you will re-invest the dividends somewhere else.
3. ROE
Thirdly, you want to see a strong return on investment. Return on equity is the most popular way of measuring a return on investment in the market.
You can find all these information freely on the Bell Direct site for each stock you're interested in just look under 'Historical Financials'.
There are many companies with growing share prices who don't utilise compounding. So do your homework.
So, the beauty of shares is that unlike almost any other investment, it can utilise the power of compounding to accelerate returns. It's all about multiplying your investment power!
by: Julia Lee
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