Return on Investment – Dutch Uncles

Rule of 72: Find Out When Your Investment Will Double

Aakash Sharma — Tue, 21 Sep 2021 05:40:09 +0000

If you are an investor, the Rule of 72 is an easy way to estimate the time it will take for your investment to get doubled, given that you get stable annual returns on it. By simply dividing 72 by the fixed interest rate, you can roughly estimate when the investment balance will double.

Interestingly, the first mention of the Rule of 72 comes from the 1494 book Summa de Arithmetica by Italian mathematician Lucca Pacioli. The book was used as a textual description for accounting studies until the mid-17th century, granting Pacioli the ‘Father of Accounting’ title.

The Rule of 72 is an easy way to calculate how long it will take to double your annual return. Investors can use this rule for rough estimates when considering financial aspects of retirement, education costs, or other long-term goals. For specific results, investors can use a more complex logarithmic formula to calculate the time it takes for doubling the investment.

What is the Rule of 72?

As we have already established, the Rule of 72 is a rule that allows investors to estimate how long it will take for their investments to double. The rule works on the assumption that a fixed annual rate of return and no additional contributions are present.

For those interested in getting a more accurate estimate of how their investments will grow over time, Rule 115 can help determine how long it will take to triple your investments. Both of these rules can help investors understand the power of compound interest. The higher the return, the less time it takes to double or triple the investment.

Using the Rule of 72

Doubling Time (number of years) = 72 / Fixed annual rate of interest

Assuming your investment portfolio has an investment balance of Rs 1,000,000, you want to know how long it will take to get it to Rs 2,000,000 at no additional cost. If the expected annual return is 7%, the simple calculation of multiplying 72 by 7 will tell that it will take 10.29 years to reach the desired double amount.

The Rule of 72 estimates the doubling time of the investment. It gives a reasonably straightforward value, primarily if you use lower interest rates instead of higher ones. It is used for situations concerning compound interest. A simple interest rate does not work very well with the Rule of 72.

The following table shows the usage of Rule of 72 in doubling your investment at different interest rates:

An elaborate example of the Rule of 72

Suppose you want to start a technology-based dairy business. As innovative as the idea sounds, the company will need a hefty investment and enormous operating costs. After contacting a large number of investors with your business pitch, you come across Private Investor XYZ. A high-net-worth individual, Private Investor XYZ agrees to invest Rs. 10,00,000 in your business.

However, the investment is subject to a fixed 12% return; otherwise, the investor will pull out. Private Investor XYZ wants to know how long it will take for their investment in your company to double in value.

Using the Rule of 72 to estimate how long the 12% compound interest investment will take to double their money, you can tell Private Investor XYZ that their investment will be doubled to Rs. 20,00,000 in: 72/12 = 6 => 6 years.

Thus, the rule is also a rapid tool for investors to weigh returns on investment with fixed gains over a long period.

Shortcomings

Even though the Rule of 72 is easy to calculate, it is not always the right approach. First of all, it requires a stable return. While investors can use the average stock market return or other benchmarks, past performance may not guarantee future successful performance prediction. Therefore, you should deeply research the expected returns and be careful with your estimates.

To quickly find out how long it will take to double your investment, use the fundamental Rule of 72 formula. However, if you are planning serious investments regarding retirement or education savings plans, consider using the logarithmic equation to ensure your assumptions are as accurate as possible. The critical thing to remember is that the Rule of 72 works best over long periods for a particular range of compound interest rates only.

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Why Is Return On Equity important: All You Need To Know

Aakash Sharma — Mon, 13 Sep 2021 08:35:09 +0000

Stock markets are best analysed by a lot of ratios. A good understanding of ratios, numbers and figures can land you in good positions as far as your stock market investments are concerned.

One such important ratio is the Return On Equity – ROE. ROE is a profitability ratio that tells about the magnitude of a company’s profits on its shareholders’ equity.

ROE formula = Net Profit / Average Shareholder Equity

Net profit, or net income, is found on the income statement of a company. Shareholders equity is located on the balance sheet of a company. Average shareholders equity is calculated from the starting and ending figures of a particular financial year.

Example

A Company ABC has a net profit of Rs. 113 crore. Its average shareholders’ equity will be calculated by the average of the opening shareholders’ equity and closing shareholders equity.

Let’s say the opening shareholders’ equity is Rs. 838 crore, and closing is Rs. 398 crore. The average will be:

(Rs. 838 crore + Rs, 398 crore)/2 = Rs. 618 crore

Now, ROE will be Rs.113 crore / Rs. 618 crore = 0.183 or 18.3%

This means that Company ABC made profits of Rs 113 on average equity of Rs. 618 crore, which is equal to ~18.3% (ROE). Generally, the ROE of a good company is at least 15%.

Why is Return On Equity important?

Before investing in stocks that are on an upward trajectory – bullish stocks – it is crucial to analyse and do fundamental research on that company’s profitability. This is an essential step in investing, and getting a clear idea of the basics makes your investment strategy sound. Return on equity allows investors to understand the performance of the company.

This indicator is even helpful in comparing two stocks in the same sector. For example, when investors compare two real estate stocks, some of their benchmarks may reflect the industry. A thorough study of an indicator like ROE can give investors a clear picture of which stocks are best to invest.

Using the ROE metric

A good or lousy return on equity ratio is not a simple figure to arrive at. But there are some fundamental guidelines to keep in mind to create a generally profitable ROE round figure. An ROE value of less than 10% can be considered a bad result.

While it may pay off first, a high return on equity is not necessarily a good thing. This is because a high return on equity can occur due to several underlying issues, including outstanding debt or profit inconsistencies. Investors should always ensure that return on equity is combined with other metrics, such as debt and return on investment (ROI), to understand the firm’s financial condition.

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It is also essential to identify that the performance of "good" or "bad" stocks may vary by industry.

For example, the share returns in the utility sector are low, opposed to the efficiency of technology stocks which is generally high. Therefore, it may be helpful to compare metrics within an industry, but comparing metrics from different sectors can give a wrong impression of a company’s performance.

Return On Equity can help to identify problems

It makes sense to ask why an above-average or slightly higher ROI is better than a double, triple, or equivalent group average. Isn’t stock with a very high return on equity great for an investor?

In some cases, an extremely high ROE is good if net income is substantial in comparison to equity due to a company’s high-grade performance. However, a remarkably high ROE is often due to a smaller equity account than net earnings, symbolising risk.

Excessive Debt

One problem that can wrongly lead to a high return on equity is over-indebtedness. If a company borrows actively, it can increase its return on equity because its equity is equal to assets minus debt. The more debt a company acquires, the less equity it can have. A typical scenario is when a company borrows a considerable amount to buy back its shares. This may increase earnings per share (EPS) but will not affect accurate growth rates.

Inconsistent profits

The problem with a high return on equity is inconsistent profit returns. Imagine that a company has not made a profit for years. The annual loss on the balance sheet is presented as a “retained loss” in equity. This loss is damaging and reduces shareholders’ equity. Suppose the company made unexpected profits last year and becomes profitable. The denominator in the ROE calculation is now minimal after many years of losses, which makes its ROE misleadingly high.

In such cases, extremely high ROE levels should be considered a warning sign and be scrutinised before investing. In rare cases, a well-managed cash flow plan can lead to a negative return on equity, but this is the least likely outcome. However, you cannot evaluate a company with a negative return on equity compared to another stock with a positive ROE.

The debt parameter is crucial in calculating a company’s return on profits and should be carefully considered before investing. As part of your research, you should view a company’s current performance and gain an in-depth understanding of its ROE history that began at least 5-10 years ago. You can find it in the company’s annual report or a much more accessible format on the investing website Screener.In.

In the end, it is essential to remember that the basics of sound investing reside in intelligent investments into financially strong and profit-making companies – these are the shares that will give you gains in the stock market.

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Should I Opt For Dividend Investing?

Aakash Sharma — Mon, 13 Sep 2021 05:35:08 +0000

As long as you buy and invest wisely, buying dividend stock can pay off over time. Some companies have lucrative reinvestment plans, commonly known as dividend reinvestment plans (DRIP). With DRIP, you can redeem your dividend earnings to make money instead of cashing the dividend out. This is an intelligent plan when your dividend income is low, either due to a business’s initial growth stage or when you do not have enough stock shares.

Investment in stocks with a growth option

The growth option on investment means that investors in the fund do not receive any dividend returns on the shares. However, the investor allows the company to give profits on those dividend earnings by choosing the growth option. This improves the net asset value (NAV) of the invested fund.

Dividend reinvestment

Dividend reinvestment opportunities are very different from growth opportunities. In reinvesting the dividends, investors purchase additional shares in a company’s stock. In simple terms, when dividends are paid out of equity, no money is distributed to investors.

Fund managers use the dividend funds to automatically buy more shares on behalf of investors and transfer them to individual investor accounts. This method increases the number of stakes over time and generally increases faster than the account’s value if the owner does not reinvest the profits.

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Shareholders can forgo growth opportunities in either of the ways mentioned above and get dividends cash immediately. In such a case, the money is paid directly to the investor.

Prefer quality over quantity

One of the most crucial concerns when choosing the dividend reinvestment avenue is profitability by dividend — the higher the product, the better the return. If the current level of a stock’s dividend payout is not long-term, then the total market profit will disappear quickly. Keep this in mind before choosing a plan.

Leading companies are promising to bet on

The stock market works in cycles and often repeats itself over and over. If you choose to invest in dividends, there is no one better than the stocks of market leaders. Established companies that have steadily increased their ROI over the past 25 years are the safest investment options for you. If brands are easily recognisable and generate a steady cash flow, they are likely to continue turning in profits for the shareholders and pay good dividends.

Purpose of having different options

Investors should make decisions based on their personal goals and financial needs. However, once the investor gains clarity on these aspects, making a choice can be pretty effortless. The net asset value (NAV) of the dividend option in an investment fund might be different in different cases. Picking the one that aligns with your aims is the best way to go.

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