One of the interesting things about investing is to understand that it only takes one great investment, held for a very long time, to change your destiny forever.

Great fortunes are not built from risking everything on a single stock that doubles or triples itself in a year.

The hardest part of investing is not about knowing the mathematical formulas, it’s about having the conviction to stick with what you know to be right and having to stay for a long period.

Basic math require for investing in stocks

These maths tools are relatively easy to understand and will help you choose the right stocks and funds. And most importantly, it will keep your expectations about future returns grounded in reality.

1. Simple algebra and arithmetic

Here are five fundamental algebraic and arithmetic equations that the savviest investors know.

Equation 1

Return on Equity (ROE) = (Net income / shareholder equity)

ROE is a classic measure of a company’s ability to put shareholders’ money to good use.

Calculate the ROE of any stock using the balance sheet and income statement of the company. Look for consistent ROE of 15% or more while investing in stocks. This will steer you towards profitable companies and away from speculation.

Equation 2

F = P * (1 + R)t

where,

  • F = Future value of the investment
  • P = Present value of the investment
  • t = The number of compounding periods and
  • R = The periodic interest rate, inflation rate or rate of return

The concept is called “future value” and it’s one of the most powerful concepts in investment.

The future value formula comes in handy if you want to figure out what your investment instrument (stocks, CDs, savings account etc) might be worth in the long run say 10 or 15 years, how high your rate of return needs to be to reach your goals and even how much money you need to save each year to hit a retirement milestone.

Equation 3

Total Return = {( Value of investment at the end of the year – Value of investment at beginning of the year ) + Dividends} / Value of investment at the beginning of the year

It is a simple calculation, but it reminds us that we need to include dividends for calculating the return of a stock.

For example, if you bought a stock for ₹7,500 and it is now worth ₹8,800, you have an unrealized gain of ₹1,300. You also received dividends during this time of ₹350.

What is the total return?

Total Return = {(₹8,800 – ₹7,500) + ₹350} / ₹7,500 = 0.22 or 22%. 

You can use this calculation for any time length, which is also a weakness since it doesn’t take into account the value of money over time.

Equation 4

Stock price = V + B * M

Where,

  • V = Stock’s variance
  • B = How the stock fluctuates with respect to the market
  • M = Market level

The above formula is the Capital Asset Pricing Model (CAPM) and is used to assess the price of a stock in relation to general movements in the stock market.

Equation 5

Price/Earnings Ratio (P/E) = Market price of Stock/earnings per share

The P/E Ratio is used to compare the price of a stock to other stocks in the same industry.

The market price of a stock is the cost of buying 1 share on the stock market and earnings per share is the annual per share earnings reported in the company’s financial reports.

If the P/E for the company is lower than that for the industry, an investor should investigate further to discover the reasons for its low price. Depending on those reasons, an investor might buy or sell it.

2. Compounding

Compounding is the most essential mathematics needed for investing.

Compounding means that the initial returns or interest that you earned on investment ( principle amount ) becomes part of the invested capital or principle.

For example,

Suppose you invested around ₹10 lakhs over 30 years and you expected a return of around @ 10% per annum, then:

Years 5 10 15 20 25 30
₹ 10 lakh grows to (Rs. Lakhs) 16.1 25.9 41.8 67.3 108.3 174.5
Compounding Effect (Rs. Lakhs) 6.1 9.8 15.8 25.5 41.1 66.1

Compounding simply means the interest earned on interest which leads to substantial growth in investments and savings over the course of time, longer the duration more powerful will be the compounding.

To take advantage of the power of compounding, it is wise to start saving and investing as early as possible.

Read more: What everybody misses about the power of compounding

3. Probabilities

The word probability theory for investing might initially cause your eyes to glaze over with boredom. But I believe I can make it practical for you and we can learn important lessons from a basic understanding of probability.

So let me ask you this question.

How do some investment advisers correctly predict short term movements in the stock market with accuracy?

But let’s look at the probability theory in a simple example.

If you flip a coin in the air you have 50% probability of getting the head and a 50% probability of getting a tail. Now if you ask 1000 people to predict the outcome of a single coin flip the chance is 50% will predict correctly and 50% will get it wrong.

But if you flip a coin twice and odds are only 25% of predictors will guess both flips correctly i.e. the accuracy of prediction will fall with each additional coin flip.

Although the stock market is much more complex than flipping a coin, the same concept applies to investment probability.

Probability helps you understand risk and reward better in any investment and is a very good tool to help understand several aspects of stock investing.

No mathematical system, however advanced, can predict the actual future of stocks, but sophisticated mathematics can calculate the probability of events.

What requires a good investment?

Good investments require these temperaments only:

  • Patience: Warren Buffet once said that some things just take time, you can’t get a baby in one month by getting nine women pregnant.
  • The ability and willingness to stick to a plan while ignoring the crowd: If you have a firm grasp of financial history and know what works, like buying any asset for less than what it is worth at attractive discounts to net present value then holding to collect dividends, interest income, and rents, you need to have the fortitude of character to remain steadfast.
  • A lot of emotional capacity to separate market fluctuations from the underlying real value of the investment.
  • To be a great investor you need the ability to value assets and businesses in the market.
  • Find the right investing path: Your level of knowledge, personality and resources should determine the path you choose.

The Bottom Line

The key to investing is to allow time to heal the wounds, be selective about what you buy, rarely sell anything, focus on real companies selling genuine products or services for real cash rather than showing fake dreams that promise instant riches and go about your life.

Happy Investing!

Disclaimer: the views expressed here are of the author and do not reflect those of Groww.