1/ Many beginners in investing wonder about the word "Compounding" in relation to Stocks. What is Compounding, exactly? Is it in the Stock price? Is it like Interest payments in a Bank? How does it work? Here's a thread to clear all these doubts. #compounding

2/ First and foremost, read the words below very, very carefully. They are important.

"If you can remember that stocks aren't pieces of paper that gyrate all the time -- they are fractional interests in businesses -- it all makes sense."

-- Seth Klarman, Baupost Group.

3/ Buying a stock makes you a Part-owner in that business. You do not own just a piece of paper or numbers on a screen. You own a business. It may only be a small part of it, but you are still an owner -- or a 'Shareholder'. With that understanding, let's proceed.

4/ Let's pick a company, Asian Paints (BSE:500820). They sell Paint. But how do they do it? It starts with the Management team commissioning a plant and acquiring machinery, then maybe tools and equipment. In Finance, we call this 'Capital Expenditure' or 'Capex' for short.

5/ Over the years, Capex piles up and we call it 'Invested Capital'. Here's the Invested Capital of Asian Paints over the last decade. Every year, they have invested Crores of Rupees, which are for -- as we discussed -- Plant, Machinery, Tools and Equipment.

6/ Great, so now the Plants can run and produce Paint. We'll skip all the processes in between and say they've managed to sell a lot of Paint. This is called 'Sales' or 'Revenue'. But this Revenue didn't appear out of this air. Many people had to work for it to come to fruition.

7/ So, it's natural that they need Salaries. Going a bit with this, they would have also consumed Electricity and Gas. Maybe other expenses too. This is 'Opex' or 'Operating Expenditure'. So a lot of the money from Sales goes towards these and we're left with 'Operating Profit'.

8/ Let's put Operating Profits over Invested Capital to figure out how much Profits they earned as a percentage of Capital - let's call it the 'Return on Invested Capital'. You can see these percentages in the below chart.

9/ Asian Paints started by investing Rs. 1795 Crs, made Rs. 1331 as Profits. Next year, they reinvested part of the Profit - Rs. 1795 Crs became Rs. 2465 Crs. On this, they earned Rs. 1511 Crs. Then they reinvested Rs. 2899 Crs and made Rs. 1737 Crs.. and so on and so forth..

10/ Does this sound familiar? It should, because this is 'Compounding'. It is a process of starting with a small amount of money, earning a small return on it, reinvesting a bit more, earning a bit more, reinvesting a lot, earning a lot and so on.

11/ Great! But how does this tie back to Stocks? Imagine you buy some Shares of Asian Paints. You are now part owner of Asian Paints, remember? As part owner, you are owed a share in all the future profits, as well as the Assets (And Liabilities) of the company.

12/ So when Asian Paints 'compounds' its Assets and Profits, the amount you are owed in the future also increases. It may not increase forever, and never in a straight line, but by virtue of being a part owner, what you are owed also certainly 'compounds'.

13/ Here come the link -- Several other people in the Stock market also own Asian Paints. Whenever they want to buy or sell the stock, they need to come up with an estimate of their preferred transaction price. They need to 'Value' Asian Paints stock.

14/ I don't want to discuss how they Value it. Let's say they do somehow based on assumptions of future Profitability and Asset positions. Since a lot of people trade Asian Paints stock every day, its Price goes up and down frantically over days, weeks, months and years.

15/ If we assume that the Profits and Assets of Asian Paints will continue to 'compound', it's reasonable to assume then that the Stock Price will also do that. Except, like we discussed the Stock Price is just an opinion - it may change any time.

16/ So really, all the 'compounding' happens at the company. The Stock Price doesn't 'compound', it simply reacts to people's opinion of the compounding happening on the ground. They may correlate over the long term. But they also may not. The market doesn't owe you anything.

17/ If a company's doing well and it's likely to do well in the future, the probability of the stock 'compounding' up is high. If the profits are sporadic or the management is fraudulent, it may not 'compound' as well. In both cases, there are no guarantees, just probabilities.

18/ This is not to scare you. Stocks in good companies generally do well. All the same, I want to make sure you understand -- when you invest in a stock, you own a company. Look at the 'compounding' happening in the company. The Share Price is just the outcome, an afterthought.