The Triple Threat of Compounding

In value investing, I often focus on what I call the “triple threat” of compounding: earnings growth (driven by factors like sales expansion), P/E multiple expansion (as the market gradually recognizes the company’s quality), and share buybacks (which reduce shares outstanding and boost earnings per share). These three elements don’t just add up—they multiply, creating explosive long-term returns when they interplay effectively.

The style I prefer involves lower-market-cap companies that are undervalued, allowing this dynamic to unfold over time. Ideally, the stock stays below its intrinsic value for years, providing management with plenty of chances to repurchase shares at attractive prices. This accretes value to remaining shareholders while enhancing the compounding effect as the business’s intrinsic value continues to grow. I especially like when P/E expansion occurs at a measured pace—it’s preferable to sidestep quick overvaluation that could deter ongoing buybacks, rather than risking rapid surges where the market might maintain elevated prices for years, potentially reducing buyback opportunities and creating a long-term setback.

To illustrate, let’s use a fictional small-cap company called Example Co., a niche manufacturer in a growing industry (like specialized industrial parts). We’ll model a 10-year scenario that fits this ideal: sales compound for a 4x earnings boost, the P/E ratio expands steadily from 7 to 14 (a 2x increase), and shares outstanding fall from 1,000,000 to 750,000 through value-adding buybacks (a 1.33x EPS uplift). The result? About a 10.6x total return on the stock price, or roughly a 27% CAGR.

Here’s where the magic happens. These aren’t isolated effects; they feed into each other:

• Earnings growth increases intrinsic value annually, widening the undervaluation gap if the P/E doesn’t expand too quickly.
• Undervaluation allows cheap buybacks, which reduce shares and supercharge EPS growth beyond just the sales-driven earnings.
• Gradual P/E expansion rewards patient holders without popping the compounding machine—management gets more time to buy back shares, further growing intrinsic value.

Let’s break down the 10-year total return multiple:

• Earnings growth multiple: 4x (15% annualized).
• P/E expansion multiple: 2x (7 to 14).
• Buyback multiple: 1.33x (25% share reduction from 1,000,000 to 750,000 shares).
• Total stock price multiple: 4x × 2x × 1.33x = 10.6x.

This translates to a stock price rising 10.6x over the decade. Your initial investment grows accordingly.

Why This Setup is Ideal:

• Never reaching intrinsic value: In this scenario, the stock stays below a growing intrinsic value for most of the period, providing prolonged opportunities for cheap buybacks.
• Ongoing growth: 15% growth keeps intrinsic value climbing, creating a virtuous cycle.
• CAGR of 27%: This crushes market averages, all from the triple threat multiplying (not adding). A 10.6x multiple over 10 years turns $10,000 into over $106,000.
• Real-world parallels: Think of overlooked small-caps like early Monster Beverage or AutoZone, where buybacks + growth + rerating created massive wealth.

This is why I hunt for these setups—patience pays when the interplay is right.