Basic Investment (Growth and Contributions)

A "basic investment" is one where you start with an initial principal, invest it at an annually compounded rate of return, and add equal contributions every year. One thing we need to get straight from the beginning is the timing of the interest and contributions. We're going to assume that the balance of the account for any particular year includes the interest growth from last year, but does not yet include the new contribution. (This is the way most people do it, but sometimes you'll see an example that assumes a different schedule; they will disagree with our formula by the equivalent of one year's interest and/or one year's contribution). We'll write c for the annual contribution; and to keep things cleaner we'll write "z" for (1 + r). Now we start writing down the account balance for the first few years: Year Now 1 2 Balance P (P + c)z ((P + c)z + c)z

In other words, to go from one year's balance to the next, you add on the contribution c, then multiply by z to get the interest. If you multiply these terms out, you'll start to see the pattern emerge: Year Now 1 2 Y Balance P Pz + cz 2 2 Pz + c(z + z ) Y 2 Y Pz + c(z + z + . . . + z )

The second part of that last line is just c times the sum of a geometric series. So you can boil the whole thing down to: 1. Balance(n) = Pz + c[(z
Y Y+1

- z)/(z - 1)]

Finally, write z out in terms of r, to get the formula we're looking for: 2. Balance(Y) = P(1 + r)
Y

+ c[ ((1 + r)

Y+1

- (1 + r)) / r ]

Timing Issues The formula above assumes contributions occur at the start of each year. If you want them to happen at the end instead, then you get one less interest period per contribution: Year Balance Now P 1 Pz + c

2 Y and the formula becomes: 2a.

Pz + c(1 + z) Y 2 Y-1 Pz + c(1 + z + z + . . . + z )

Balance(Y) = P(1 + r)

+ c[ ((1 + r) - 1) / r ]

Annuity
Among other reasons, annuitized payouts are important because they're the key to retirement accounts. You start with a lump sum at the start of retirement, and assume it's invested at a set rate of return. Then you start to draw money out annually, for income. The problem is to find how much these annual withdrawals can be without depleting the account too early. To keep things simple, we'll assume that the withdrawals are all equal.

First of all, let's take a moment to appreciate that this is not a simple problem, because it incorporates two conflicting trends: you have compound interest building the account up; at the same time you've got the investor greedily trying to suck it dry. We'll write w for the annual withdrawal amount, and again write z for (1 + r) to keep things neater. Writing out the first few terms for the balance, Year 1 2 3 Balance P-w (P - w)z - w [(P - w)z - w]z - w

Multiplying the right sides out yields the pattern: Year 1 2 3 Y Balance P-w Pz - w(1 + z) 2 2 Pz - w(1 + z + z ) Y-1 2 Y-1 Pz - w(1 + z + z + . . . + z )

The second part of the last line is w times the sum of a geometric series. So the formula simplifies to: 1. Balance(Y) = Pz
Y-1

- w[(z - 1)/(z - 1)]

We're assuming that P, r, and Y are all known and that we want to find w that makes the balance go to zero at time Y; so set Balance(Y) = 0 and solve for w, to get: 0 = Pz - w[(z - 1)/(z - 1)] Y-1 Y w = [Pz ]/[(z - 1)/(z - 1)] Y-1 Y w = [Pz (z - 1)]/[z - 1]
Y-1 Y

2.

Finally, write z out in terms of r, to get the annuity formula: 3. w = [ P(1 + r)

Y-1

r ] / [ (1 + r) - 1 ]

Timing Issues The formula above assumes payouts occur at the start of each year (the idea being that that's the most natural assumption for a retirement account - you need to withdraw money now to live on for the rest of the year). Technically that's an annuity due - an ordinary or immediate annuity assumes you get payouts at the end, which essentially means you get one more period of compounding before each payout: Year 1 2 3 Y Balance Pz - w 2 Pz - w(1 + z) 3 2 Pz - w(1 + z + z ) Y 2 Y-1 Pz - w(1 + z + z + . . . + z )

Solving for w thus gives you one more year of growth: 3a. w = [ P(1 + r) r ] / [ (1 + r) - 1 ]
Y Y

(The annuity calculator will let you see how much of a difference this makes.)

Present Value of an Annuity If you solve either equation 3 or 3a for P, you get the formula for the present value of an annuity, i.e. the starting principal you'll need to achieve the payouts desired: 4. (annuity due) 4a. (ordinary annuity) P = w [ (1 + r) - 1 ] / [ (1 + r) r ] Y Y P = w [ (1 + r) - 1 ] / [ (1 + r) r ]
Y Y-1

Mortgage
You can think of a mortgage as either building up equity or paying off debt. Although the payments are all equal, equity doesn't build up at a constant rate: that's because at the beginning the debt is still high, so most of the payments are paying interest; toward the end, the remaining debt is small so very little of the payment goes toward interest.

Note that for convenience we're showing the payments as annual rather than monthly. Obviously nobody really does it that way, so if you want the correct number for a monthly payment on a mortgage use the calculator (or see the example below). Also, to make the graph look nicer we're showing debt at the beginning of each year, and equity at the end. If you look at what's happening to the debt, you'll see it's similar to an annuity only now you're paying the balance off rather than using it up. Also, the timing is slightly different: you make your first payment at the end of the first year. We'll write "a" for the annual payment amount, and as usual write z for (1 + r); P is the initial loan amount, and r is the loan interest rate expressed as a decimal. Writing out the remaining debt at the end of the first few years, Year 1 Debt Pz - a

2 3

(Pz - a)z - a [(Pz - a)z - a]z - a

Multiplying the right sides out yields the pattern: Year 1 2 3 Y Debt Pz - a 2 Pz - az - a 3 2 Pz - az - az - a Y 2 Y-1 Pz - a(1 + z + z + . . . + z )

The second part of the last line is a times the sum of a geometric series. So the formula simplifies to: 1. Debt(Y) = Pz - a[(z - 1)/(z - 1)]
Y Y

We're assuming that P, r, and Y are all known and that we want to find a that makes the debt balance go to zero at time Y; so set Debt(Y) = 0 and solve for a, to get: 0 = Pz - a[(z - 1)/(z - 1)] Y Y a = [Pz ]/[(z - 1)/(z - 1)] Y Y a = [Pz (z - 1)]/[z - 1]
Y Y

2.

Finally, write z out in terms of r, to get the mortgage formula: 3. Example Suppose you take out a 30 year mortgage for $100,000 at 7% interest, and want to know the monthlypayments. To do that, you divide the interest rate by 12 to get (.07/12) = .00583; and multiply 30 x 12 = 360 to get the number of payments. Then the formula gives you: payment = [$100,000(1 + .00583) = $665
360

a = [ P(1 + r) r ] / [ (1 + r) - 1 ]

x .00583] / [(1 + .00583)

360

- 1]

(The current fair market value is equal to the sum of the heights of all of the green bars, which are thepresent values of the corresponding blue bars.) (See more detail.) To get the formula, we'll define some variables: E = this year's Earnings per Share G = growth rate of earnings (written as a decimal) N = number of years earnings will grow We're assuming that earnings will start to grow for N years, and then level off:

Year 1 2 N N+1 N+2

Earnings E(1 + G) 2 E(1 + G) N E(1 + G) N E(1 + G) N E(1 + G)

Now we'll write R for our desired rate of return, and use it to find the present values of all of these earnings: Year 1 2 N N+1 N+2 Present Value of Earnings E(1 + G)/(1 + R) 2 2 E(1 + G) /(1 + R) N N E(1 + G) /(1 + R) N N+1 E(1 + G) /(1 + R) N N+2 E(1 + G) /(1 + R)

What we've got here is two geometric series; one going from 1 to N, and the other going from N + 1 to infinity. The result is basically too ugly to bother writing out; it's more sensible just to use the formula for the geometric series in a spreadsheet or computer program. When people do write it out, they usually write it this way: P = E1Q + E2Q + ... + ENQ
2 N

+ ENQ x Q/(1 - Q)

where E2 is the earnings in year 2 (or whatever) and Q is the so-called "discount factor" 1/(1 + R).

Zero-Growth Case
One special case is actually interesting to write out though. If you assume that the stock is already in the "mature", zero-growth years -- ie, that N is zero -- the geometric series formula will simplify to: P = E/R or, equivalently, P/E=1/R So if you take a desired return of 11%, you find that the theoretical "fair" P/E ratio of the zero-growth stock is 1/.11 = 9.09, which sounds reasonable.

Constant-Growth Case
A second special case that people use is the "constant growth forever" case, meaning N is infinity. The formula in this case simplifies to P = E1 / (R - G) where E1 is earnings over the next 12 months.

This approach can be dangerous. Constant growth forever means the company is going to get infinitely big, which is a hard concept to fit into a common sense understanding of valuation. The formula will give you a number as long as the growth rate G is less than the discount rate R; but you can force it to give you a ridiculously huge number if you make G very close to R. This graph won't let you try that - the blue bars could blow through the top of your screen and hurt somebody - but you can see it happen in the discounted cash flows calculator in the stock valuation article.