1 Crucial Formula Investors Must Understand

“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”

What you see above is a quote frequently attributed to the great physicist Albert Einstein. It’s hard to verify if Einstein actually said or wrote that, but the wisdom in it is still apparent.

Here’s a simple example of how compound interest works. Say you had invested a sum of $10,000 that grows at a compound annual rate of 10% indefinitely. After the first year, you’d have $11,000. But in the second year, you’d have $12,100 and not just $12,000; the 10% return on the second year actually applies to the $11,000 and not the original principal sum of $10,000. So, in the third year, you’d end up with $13,310 and off the snowball rolls.

By the 20th year, you’d have $67,275, which is nearly seven times your initial investment of $10,000. In contrast, an investment which gives 10% simple interest will only be worth $30,000 after 20 years ($10,000 in principal plus $20,000 in interest).

Mathematically, the formula for compound interest is this:

Future Value = Current Value x (1 + Interest Rate)^(number of years).

Compound interest is a powerful concept for investors to know. If a business can grow its profit at 10% annually over the long-term, it can become a very valuable business. Remember how a $10,000 investment becomes more than $67,000 in just 20 years? And the thing about growing profits is that a stock’s price tends to follow its business performance over the long-term.

Gloves maker Riverstone Holdings Limited (SGX: AP4) provides a great example. The company has grown its earnings per share at a compound annual rate of 21% from 2007 to 2015. Meanwhile, the company’s current share price of S$0.92 represents a compound annual growth rate of 19% since its listing on November 2006.

As investors, understanding the existence of compound interest is just the first step. More importantly, we need to understand how we can benefit from compound interest too.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Lawrence Nga doesn’t own shares in any companies mentioned.