10 May 2016Importance Of Compounding In Valuation
Investing is the act of committing money or capital to an endeavor with the expectation of obtaining an additional profit. For any investor, assessment of fair value of a security is of paramount importance before investing to assess the real worth of their investment because what one pays is price and what is received is value. Hence, one needs to assess the valuation/ fair value of the security and is also required to estimate its future potential for value creation (compounding).
Valuation means estimating what an asset’s worth is and compounding is the process of accumulating the time value of money forward in time. Hence, it is important for an investor to know what is undervalued or overvalued and if a company/asset is undervalued then, what maximum value it can reach (compounding). Let’s look at three scenarios which explain how compounding, an important role plays in valuation: –
• Every company wants to increase shareholder’s wealth by investing in those projects that will boost company’s profit which in turns, increase the share price and if intrinsic value shows that share is undervalued, then investor holds their money until the shares price reaches its maximum. Let’s take an example:-
Alphabet Inc. (Google) has been investing in R&D for several years and came up with a new technology “Project Loon” by using blue ocean strategy to deliver high speed internet to Sri Lankans and many more countries using balloon.
Suppose, an investor had purchased few shares of Alphabet, Inc. (Google) at $561.39 and now price is $705.06 shows earning has already increased by approx. 25.59% and if “Project Loon” would be successful and share price would touch ~$1000 so, one’s earning could be increased by approx. 78.12% instead of 25% every year, that’s called compounding because of increase in equity value of company.
• Similar is the case of zero-coupon bonds. A zero-coupon bond is one that makes no periodic interest payments and is sold at a deep discount from face value which shows maximum effect of compounding. The buyer of the bond receives a return by the gradual appreciation of the security, which is redeemed at face value on a specified maturity date.
For example: If an investor purchases a zero coupon bond of a company having face value of $1000 at $546.22 which matures in three years. Hence he is earning approx. 15% interest per year on his investment which is not provided explicitly.
• A start-up company can either raise money to fund operations through equity or debt. By raising money through equity, owners dilute their ownership hence when entrepreneurs does not want to dilute their ownership they resort to raising capital through debt. Venture debt funds usually invest in private equity backed companies and take 12-15% interest and sometimes negotiate warrants (option to buy share in near future) for upside potential. Hence, if the company is growing at 10% month over month, paying 15% a year in interest is much cheaper than selling equity that is growing at approx. 200%+ a year. Therefore, making it beneficial for both the parties as one is assured of their returns and other one has access to a relatively cheaper fund source.
To conclude, Compounding is an integral part of increasing the value of an investment. However, It is difficult to calculate the value by analysing different factors and invest billions of dollar just on the basis of valuation models is risky but, if your forecasting is right and you know market better than others then, you will get return on compounding basis.