Why earning 'interest on interest' is called compound interest???

Why is 'Interest on Interest' Called Compound Interest?

Compound interest refers to the interest earned not only on the initial principal but also on the interest that accumulates over previous periods. In simpler terms, it’s "interest on interest." This compounding effect causes the investment to grow at a faster rate compared to simple interest, which is calculated only on the original principal amount.

Example: Compound Interest vs. Simple Interest

Let’s take an example to illustrate this. Suppose you invest $100 at an interest rate of 10% per year for 3 years.

• Compound Interest:
  In year 1, you earn $10, making your total $110.
  In year 2, you earn 10% on $110, which gives you $121.
  In year 3, you earn 10% on $121, which totals $133.1.
  So, the total amount after 3 years would be $133.1, where the extra $3.1 is the "interest on interest."

• Simple Interest:
  If you use simple interest, you earn $10 each year based on the original $100 principal. After 3 years, you will have $130, with no additional interest on interest.

Therefore, compound interest results in more growth due to the reinvestment of earned interest over time.

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Key Factors in Common Stock Valuation

Common stock valuation involves determining the present value of a company’s ordinary shares. To do this, two major factors must be considered:

1. Future Benefits: These include dividends and potential capital gains expected from holding the stock.

2. Present Value Calculation: The total future benefits must be discounted back to their present value using a discount rate. This technique helps determine the fair value of the stock today.

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Why is Equity Share Valuation Difficult?

Valuing equity shares can be challenging due to two main reasons:

1. Uncertainty of Dividends: Unlike bonds, where interest payments are fixed, equity dividends are not guaranteed. The company may choose whether to pay dividends and by how much, adding uncertainty to cash flows.

2. Dividend Growth: Earnings and dividends of equity shares are expected to grow over time. This growth makes it harder to predict future cash flows, compared to fixed-income investments like bonds, where payments remain constant.

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Methods of Valuing Shares

Despite the challenges, there are several models used to value equity shares:

1. Single-Period Model

This model evaluates the stock based on expected returns for a single time period.

2. Multi-Period Model

The multi-period model estimates the stock’s value by forecasting returns over multiple periods.

3. Perpetual Investment Model

In this model, stocks are valued assuming that dividends continue indefinitely.

4. Growth in Dividends Model

This model focuses on stocks where dividends are expected to grow over time, such as using the Gordon Growth Model, which assumes a constant growth rate in dividends.

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By considering these models and factors, investors can better assess the fair value of a company’s shares, despite the inherent complexities involved in equity valuation.

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