CAGR (Compound Annual Growth Rate) : Introduction and calculation
If you wish to accurately determine returns on investment portfolios and assets that fluctuate with time, then you should use the Compound Annual Growth Rate (CAGR).
It depicts the annual growth rate of an investment over a specified time period that is greater than 12 months.
CAGR is used to measure the profitability of various businesses and is often associated with specific parameters such as earnings, sales, revenue, etc.
Let’s understand what exactly it means!
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Everything You Need To Know About CAGR
As stated earlier, CAGR helps investors in finding out a constant rate of return for an asset over a specific period of time. With CAGR, investors can easily find out what they actually have at the end of their period of investment. The CAGR can be calculated by using a simple mathematical formula.
CAGR = (Vfinal / Vbegin)1/t – 1
Where Vbegin is the beginning value, Vfinal is the final value, and t is the time in years.
CAGR is one of the best ways to indicate the value investors will receive as return after their investment period has ended.
Let us understand this with an example:
You invested $1,500 at the beginning of 2018.
By the end of the year, your investment was worth $4,500, which means a 200 percent return.
Unfortunately, the next year, you end up with $2,250. This means you lost 50 percent.
Therefore, in order to calculate your annual return for the period, you need to use the CAGR formula.
How to Calculate CAGR?
Many investors analyze the performance of their investment on the basis of absolute returns. However, it lacks in considering the time value of money.
CAGR takes into account the time period for which you invested, thus providing a more accurate and approximate rate at which your investment will expand.
Moreover, it proves to be an excellent way to figure out the fluctuations faced by the assets over a particular time period. This allows you to easily interpret its performance and to determine how a given investment fared as compared to its price.
And when it comes down to calculating compound annual growth rate, you need to consider these three steps. You should know all these three numbers:
- Value of investment in the beginning year.
- Value of investment in the final year.
- Investment’s tenure.
What Should You Know About CAGR?
If you’re an investor, there are some important things you must know about CAGR.
- CAGR and year-on-year growth rate (e.g., return on 23 March 2019 vs that on 23 March 2020) are not the same.
- CAGR does not indicate the sales that happened from the beginning year to the final year. Sometimes, the entire growth may concentrate at the beginning or the final year.
- It is possible that two investments reflect the same CAGR. This is possible due to the faster growth in the initial year for one, and the final year for the other.
- Usually, CAGR exhibiting the investment periods from three to seven years are employed. In case the tenure is more than 10 years, then the CAGR could possibly hide the sub-trends in between.
Pros and Cons of CAGR
CAGR is undoubtedly the most reliable parameter to estimate the growth of your investment.
It is because it takes compounding into consideration unlike the absolute rate of returns, thus providing a more precise estimation. However, there are certain pros and cons of this instrument.
Let’s now have a look at the pros and cons of CAGR:
Pros of CAGR
Some of its major benefits are:
- It allows investors to compare and measure the past performances in different time horizons of investments. This comparison assists in understanding the performance of your investments relatively.
- It is also helpful in comparing the performance of one stock with the other.
- It helps you to figure out the expected returns of your investments.
- It helps you to provide risk-free instruments to measure the returns of a specific investment.
Cons of CAGR
The following are the cons of CAGR you should know.
Not an Indicator of Market Volatility
Investment results may vary over a significant period. While making investment decisions, it is important to focus on market volatility.
Unfortunately, CAGR does not take into account the important factor of stock market fluctuations, which usually have a tremendous effect on the performance of various companies.
Despite the existence of market volatility, CAGR assumes that investment grows at a steady rate.
Imperfect for Risk Assessment
Owing to the fact that CAGR does not indicate market volatility, various individuals may not attain a clear idea about the performance of their investments in extreme fluctuations.
Such investment risks are also important to consider while taking decisions regarding investments. However, CAGR does not consider short term variations. Therefore, it is not an ideal parameter to assess investment risks.
You Need Extra Tools
The compound annual growth rate, as mentioned above, cannot grasp the short-run irregularities experienced by the stocks because of several internal as well as external factors.
Therefore, you will certainly need some extra tools to analyze these factors.
It Can Be Easily Manipulated
As CAGR value is confined to a specified period, it is prone to manipulation.
For example, your investment fund may tell you that it has achieved an impressive CAGR of 45% over four years, but the beginning value of the investment may be considered as the lowest point that the fund has ever possessed.
Frequently asked Questions (FAQs)
Are you loaded with questions in your head pertaining to CAGR? If so, then this FAQ section will address all your queries.
Q: Who Uses CAGR?
It is used by both the investors as well as the companies to evaluate how various investments have grown and performed over time.
CAGR is an easy metric to compare with other investments so that companies can understand which investment can offer them higher returns.
Q: Is CAGR similar to the Average Annual Growth Rate?
No. CAGR and Average Annual Growth Rate are not the same metrics. CAGR is a statistic instrument based on the growth that measures the compound annual return of investments over a specific period.
Whereas, AAGR (Average Annual Growth Rate) is a simple growth metric that does not take into account compounding. It calculates the arithmetic average of an investment.
AAGR may prove better in predicting trends, but CAGR is unbeatable in analyzing the growth of your investment.
Q. When should one use CAGR and AAGR?
If your comparison needs to be in the longer-term, let us say from 5-10 years, then Compound Annual Growth Rate is the best tool. It is because it can describe the long-term or historical performance of an investment.
If you need to estimate your future returns from a particular investment, then AAGR is the best tool. It is because it offers results based on past performances.
Moreover, it is unbiased in its estimation of future returns.
The Bottom Line
We can say that CAGR is a valuable tool to evaluate the returns of your investments. However, it doesn’t tell you the whole story. It does not consider volatility, fluctuations, and other market risks.
Therefore, it is always recommended to evaluate the performance of your investments using other tools and metrics along with CAGR.
While taking investment-related decisions, you should not solely rely on one factor or tool. The use of other measures is also important to get a clear view of the picture.
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