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The original was posted on /r/explainlikeimfive by /u/hopewheres on 2023-06-26 23:12:35+00:00.
Why would a stock be deemed compounding if it pays no dividends?
Based on Investopedia’s definition:
Compound interest is the interest on savings calculated on both the initial principal and the accumulated interest from previous periods.
“Interest on interest,” or the power of compound interest, will make a sum grow faster than simple interest, which is calculated only on the principal amount. Compounding multiplies money at an accelerated rate.
If you buy 1 share ($1000) in this company and it grows 10% every year, you do not get compounding because you don’t get money to reinvest which would increase your sum invested and thus increase the interest or dividend you receive but rather to get a ‘compound’ return the value of the company has to grow exponentially.
| Company Value | Number of Shares | Value Per Share | |
|---|---|---|---|
| Year 0 | 10000 | 10 | 1000 |
| Year 1 | 11000 | 10 | 1100 |
| Year 2 | 12100 | 10 | 1210 |
| Year 3 | 13310 | 10 | 1331 |
How come this effect is called compounding if it is completely different? Is there a different term for this?
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