Warren Buffett believes that compounding is the secret to becoming really rich. Now, to confirm his belief it is necessary to understand what compounding is.
I'll try to explain it in plain terms. Let's suppose you have decided to invest $100,000 in Company A for a term of five years at a fixed interest rate of 10% per year. That original investment of $100,000 will increase by the end of each of the five years if you earn that return and do not spend it. The additional amount in interest rate that you will start earning every year will become principal for the next. Here is a small chart that will illustrate what I'm saying.
By the end of the five-year period you would have earned $161,051. And just imagine if you invest $100,000 for a 30-year period. My Gosh! Buffett is right in believing in this formula, isn't he? And take notice that this is an example given with a fixed annual interest rate of 10%. Think of how principal would raise if you add five percentage points every year.
You are astonished; you are thinking of stopping reading and going to invest. Wait! Don't rush, there is still more to say.
Buffett's best move is to seek the highest annual rate of return possible for the longest period of time. He has been doing so with Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) and he has succeeded. But what about personal income tax? Every time you receive the interest rate earned on principal, the IRS will definitely come for you. And depending on income, the applicable tax rate may be up to 30%.
How is it possible to buy stock that compounds for 10 years at 10% a year and only pay 30% of taxes at period end? Instead of Company A paying that 10% at the end of each year and subject it to personal income tax, it automatically reinvests it in the principal. By doing so, you skip the personal income tax the IRS levies every year until the expiration of the 10-year term, when the company pays you back principal with interest.
That makes investing worth. Unfortunately, the IRS has found that this method is being used and will levy tax anyway.
However, Buffett has noticed that the IRS has missed an important point. He considers stocks in a way similar to a bond. The difference between the latter and a normal bond is that the rate of return in equity is not fixed and fluctuates with the company's earnings. And what the IRS has missed is that in this case, personal income tax is not levied until the amount earned is not paid out as dividend.
In a nutshell, earnings reported by a company represent net amounts; that is to say, after tax has been deducted. Therefore, those earnings have already been subject to tax and will no longer be so unless dividends are distributed, in which case, personal income taxes will be levied on them.
Until the equity/bond becomes due, it will compound at a high rate of return. Meanwhile, you can take a break, just like Buffett does. Actually, in the last 32 years, Berkshire Hathaway has been able to earn an average annual compounded rate of return on invested capital of nearly 23%.
You are probably speechless. But just a final tip to consider: price. Do not follow those who say that having found an excellent business and being able earn great amount of money means that the price you paid for is a minor data. They are wrong. Take a look at this case:
You decided to invest $100 in McDonald’s (MCD, Financial) at $6.07 a share in 1955. With time, it would have compounded annually at 21.9% and amounted to nearly $2,000.000 by 2011. Now, what would have happened if you have invested that same amount at $10.36 a share that same year? It would have compounded annually at 15.56% and amounted to nearly $1,400,000 by 2011. A $600,000 difference. Then, is price important or not?
Despite other investors’ thoughts, Buffett is on the correct path. And Berkshire Hathaway is clear evidence of this.
I'll try to explain it in plain terms. Let's suppose you have decided to invest $100,000 in Company A for a term of five years at a fixed interest rate of 10% per year. That original investment of $100,000 will increase by the end of each of the five years if you earn that return and do not spend it. The additional amount in interest rate that you will start earning every year will become principal for the next. Here is a small chart that will illustrate what I'm saying.
| Year | Principal | Rate of return | Return earned | Principal + return |
| 1 | 100,000 | 10% | 10,000 | 110,000 |
| 2 | 110,000 | 10% | 11,000 | 121,000 |
| 3 | 121,000 | 10% | 12,100 | 133,100 |
| 4 | 133,100 | 10% | 13,310 | 146,410 |
| 5 | 146,410 | 10% | 14,641 | 161,051 |
By the end of the five-year period you would have earned $161,051. And just imagine if you invest $100,000 for a 30-year period. My Gosh! Buffett is right in believing in this formula, isn't he? And take notice that this is an example given with a fixed annual interest rate of 10%. Think of how principal would raise if you add five percentage points every year.
You are astonished; you are thinking of stopping reading and going to invest. Wait! Don't rush, there is still more to say.
Buffett's best move is to seek the highest annual rate of return possible for the longest period of time. He has been doing so with Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) and he has succeeded. But what about personal income tax? Every time you receive the interest rate earned on principal, the IRS will definitely come for you. And depending on income, the applicable tax rate may be up to 30%.
How is it possible to buy stock that compounds for 10 years at 10% a year and only pay 30% of taxes at period end? Instead of Company A paying that 10% at the end of each year and subject it to personal income tax, it automatically reinvests it in the principal. By doing so, you skip the personal income tax the IRS levies every year until the expiration of the 10-year term, when the company pays you back principal with interest.
That makes investing worth. Unfortunately, the IRS has found that this method is being used and will levy tax anyway.
However, Buffett has noticed that the IRS has missed an important point. He considers stocks in a way similar to a bond. The difference between the latter and a normal bond is that the rate of return in equity is not fixed and fluctuates with the company's earnings. And what the IRS has missed is that in this case, personal income tax is not levied until the amount earned is not paid out as dividend.
In a nutshell, earnings reported by a company represent net amounts; that is to say, after tax has been deducted. Therefore, those earnings have already been subject to tax and will no longer be so unless dividends are distributed, in which case, personal income taxes will be levied on them.
Until the equity/bond becomes due, it will compound at a high rate of return. Meanwhile, you can take a break, just like Buffett does. Actually, in the last 32 years, Berkshire Hathaway has been able to earn an average annual compounded rate of return on invested capital of nearly 23%.
You are probably speechless. But just a final tip to consider: price. Do not follow those who say that having found an excellent business and being able earn great amount of money means that the price you paid for is a minor data. They are wrong. Take a look at this case:
You decided to invest $100 in McDonald’s (MCD, Financial) at $6.07 a share in 1955. With time, it would have compounded annually at 21.9% and amounted to nearly $2,000.000 by 2011. Now, what would have happened if you have invested that same amount at $10.36 a share that same year? It would have compounded annually at 15.56% and amounted to nearly $1,400,000 by 2011. A $600,000 difference. Then, is price important or not?
Despite other investors’ thoughts, Buffett is on the correct path. And Berkshire Hathaway is clear evidence of this.
