Financial compounding is the ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.

Here’s an example:

Joe invests $5,000 in Apple.  After first year, the share price rises 20%; his investment is now worth: $6,000 ($5000 x 0.2 = $1,000).  Let’s say he holds that stock for another year. In year 2, shares appreciate again another 20%.  Now Joe’s investment of $6,000 grew to $7,200 ($6000 x 0.2 = $1,200).  Because the 20% appreciation was calculated against $6,000 in the second year. That’s an additional $200 compounded after 2 years.

Fact, $5,000 invested at 20% annually for 25 years would grow to $476,981.