Knowing how CAGR works will enable you to examine two time periods side by side to observe how they differ and analyze growth over time more effectively.
You can compare investments using various tools to determine which will most likely offer you higher returns. The compound annual growth rate (CAGR), which gives you a hypothetical constant growth rate for an investment or asset, is one of the most useful. However, what is CAGR? Utilize our straightforward tutorial to learn everything there is to know about the compound annual growth rate formula. Explore compound interest definition first.
What is Compound Interest?
Gains on an investment are often reinvested with the original investment, a phenomenon known as compound interest. When this occurs, future interest is earned from both the initial investment and reinvestment interest, which might eventually have a snowball effect.
A fundamental idea in long-term investing is compounding interest. It also explains a crucial feature of compound annual growth rate (CAGR), which displays the growth rate of an investment over time, providing that any interest earned on the investment was reinvested at each interval.
CAGR Definition
What does CAGR mean, then? Compound annual growth rate, plain and simple. CAGR measures an asset or investment’s annual growth rate over a specified period of time while assuming compound growth.
The past performance of investments is frequently evaluated and compared, or their anticipated future investment returns are projected.
The rate of return (RoR) needed for an investment to increase from its beginning balance to its ending balance, providing profits were reinvested after each period of the investment’s life span, is known as the compound annual growth rate (CAGR).
It’s crucial to remember that the compound annual growth rate (cagr) formula does not give you the actual return rate. Instead, it provides a representational figure that illustrates the pace at which your investment would have increased had it increased at the same rate every year.
CAGR assumes a constant growth rate over the period you’re considering, which frequently doesn’t correspond to how investments function.
In essence, CAGR provides the answer to the question: Assuming that growth was taken into account annually, how much, on average, did something rise in value throughout a number of years? This makes CAGR a valuable tool for obtaining a broad perspective on growth over a more extended period of time rather than focusing on just one or two years. Check out the detailed guide about gross revenue.
What is the Compound Annual Growth Rate (CAGR) Formula
The following compound annual growth rate formula can be used to calculate CAGR:
CAGR = [(Ending Value / Beginning Value)^(1/n)] – 1
OR CAGR = [(Ending Balance / Beginning Balance)^(1/n)] – 1
Where:
- Ending Value = is the value of the investment at the end of the investment period
- Beginning Value or Starting Value = is the value of the investment at the beginning of the investment period
- n = is the number of years you have invested
To determine an investment’s CAGR:
- Divide the investment’s worth at the end of the time by its value at the start of the period.
- The result should be multiplied by one and divided by the number of years.
- The outcome is then reduced by one.
- To convert the response into a percentage, multiply by 100.
Consider, for example, a $10,000 three-year investment by your company in Investment Fund X. If each year’s investment’s year-end value is as follows:
- Year 1 – $8,000
- Year 2 – $10,500
- Year 3 – $14,000
The compound annual growth rate formula can be used to calculate CAGR in the following way:
CAGR = [($14,000 / $10,000)^(1/3)] – 1 = 0.117 = 11.87%
If you’d prefer, various compound annual growth rate calculators are offered online. Use this CAGR calculator from CAGRCalculator.net as an example rather than performing the computation by hand.
CAGR Calculator and Mutual Funds
You may find out the annual rate at which your investment has grown using the CAGR calculator, a straightforward online tool. You only need to enter a few pieces of information; the calculator will take care of the rest.
You must enter:
- The beginning value of the investment
- The ending value of the investment
- Number of years of investment
Once you enter this information, the calculator will immediately inform you of the investment’s compound annual growth rate.
Holders of mutual funds can benefit significantly from the CAGR calculator. You can use this calculator to determine how well your funds are doing and to make the required investment decisions.
The following are some uses for a CAGR calculator:
Improved investment choices: The CAGR calculator is a beneficial tool to use each year as you assess your investing choices. The CAGR calculator, for instance, will show you the average annual return you have received over the last five years if you bought equity mutual funds five years ago. This might assist you in determining whether or not the fund’s returns meet your expectations. If the fund isn’t doing well, you might want to think twice about making that investment in the future.
Compare the performance of various funds and benchmarks: The CAGR calculator can also be used to contrast the returns you receive from one fund with those of other investment funds of a similar type. This can aid in your understanding of the mutual fund’s performance compared to its competitors. For added clarity, you can also evaluate against the benchmark indices. Find the guide about annual contract value.
Why is CAGR Useful to You
Most of the time, people look at returns in absolute terms. For example, consider investing $1,000 for three years in a particular mutual fund. The investment you made increased in value to $1,850 by the conclusion of the third year. Over the last three years, your fund has produced a return of 85% in absolute terms.
You could say that at this time, your money has almost doubled. This, however, might be a little deceptive. It does not indicate how much your investment has increased for the year. CAGR is quite helpful in this situation.
Here, let’s calculate the CAGR to understand its benefits.
CAGR = [(1850/1000)^(1/3)] – 1
OR
C A G R = 23%
In other words, during the past three years, your investment in the fund has generated an average return of 23% per year.
In essence, CAGR informs you of the annual rate of compounded returns you receive, regardless of the fund’s specific annual performance.
This is because the growth of your investments varies from year to year at the same rate. As a result, you might get strong returns while seeing lower returns in other years. In actuality, it is also conceivable to experience negative returns.
CAGR gives you information on the yearly average returns that a fund has generated over a specific period of time. This rate of return is not accurate. Instead, it is a graphical representation of how much your investments would grow if they increased each year simultaneously.
More CAGR Uses
One may determine the average growth of a single investment using the CAGR. However, investment growth from year to year is likely to appear unpredictable and unequal due to market volatility.
As an illustration, an investment’s value might rise by 8% one year, fall by -2% the next, and rise by 5% the following year. When growth rates are anticipated to be unpredictable and erratic, CAGR aids in smoothing results.
Track Performance
The success of many business measures for one or more organizations can also be monitored using the CAGR. For instance, Big-Sale Stores’ market share CAGR over five years was 1.82%, while its customer satisfaction CAGR during the same time period was -0.58%. Comparing the CAGRs of several indicators within an organization might highlight its strengths and flaws.
Comparing Investments
Comparing various investment options can be done using the CAGR. For example, investors can assess how well one stock did compare to other companies in a peer group or a market index by comparing the CAGR of two or more alternatives. This acts as a compass for the investor’s investment performance.
Note: The CAGR does not, however, reflect investment risk.
For example, an investor invested $10,000 in a stock mutual fund and another $10,000 in a five-year account with a fixed yearly interest rate of 1%. It would be challenging to compare the two investments because the rate of return in the stock fund will fluctuate throughout the following years.
Let’s say that after five years, the savings account balance is $10,510.10, and the ending value in the stock fund balance is $15,348.52, notwithstanding the other investment’s inconsistent growth. CAGR helps an investor understand the variance in returns by comparing the two investments:
Given that the stock fund has generated roughly nine times the return of the savings account, it may appear to be a better investment. The CAGR’s ability to smooth the returns, however, prevents it from being able to convey to an investor how risky or unpredictable a stock fund is.
Detect Weakness and Strengths
It will be possible to assess the competitive advantages and disadvantages of different organizations by comparing the CAGRs of their business activities. For example, in contrast to SuperFast Cable’s customer satisfaction CAGR of -6.31% during the same time period, Big-customer Sale’s satisfaction CAGR might not appear as poor.
How Investors Use the CAGR
Understanding the CAGR calculation formula is a good starting point for learning about various techniques used by investors to assess previous performance or forecast future values. For example, the formula can be algebraically modified to determine the present value or future value of money or to calculate a hurdle rate of return.
Consider a scenario where a potential investor has $15,000 to invest and is aware that they would need $50,000 in 18 years to pay for a child’s college education. How much must the average rate of return be to accomplish that goal? The following can be done to determine the solution using the CAGR calculation: Consider a scenario where a potential investor has $15,000 to invest and is aware that they would need $50,000 in 18 years to pay for a child’s college education. How much must the average rate of return be to accomplish that goal? The following can be done to determine the solution using the CAGR calculation:
The present or initial value and future value equations have been rearranged in this version of the CAGR formula. An investor might use this formula to determine how much money they would need to invest to reach their objective, for instance, if they knew they needed $50,000 and thought it acceptable to expect an 8% yearly return on their investment.
What is Considered a Good CAGR?
The definition of a decent CAGR will vary depending on the situation. However, investors will generally assess this by considering the investment’s risk and opportunity cost. For instance, if a company saw 25% growth in a sector where the average CAGR was closer to 30%, its performance could appear underwhelming in contrast. But, on the other hand, its CAGR may be outstanding if the industry’s growth rates are lower, like 10% or 15%.
A higher CAGR is preferable in general.
What distinguishes the CAGR from the average annual growth rate?
CAGR calculates an investment’s growth rate across several specific periods (and assumes compounding over that period). For example, a venture capitalist may be measuring the growth rate of a possible investment, or it may be a retail investor gauging the return on a stock. Contrarily, the average annual growth rate (AAGR), also known as the arithmetic mean of a series of growth rates, measures the average increase in the value of an asset or investment for a year.
The average annual growth rate (AAGR) is derived as the overall average growth rate throughout all periods divided by the total number of periods . It’s the average of several periodic return growth rates. It’s important to remember that AAGR must be calculated with equal-length time periods, such as weeks, months, or years.
Limitations of Compound Annual Growth Rate (CAGR)
Although CAGR can be a beneficial tool, there are a few drawbacks that you should be aware of.n
The formula’s greatest strength is also one of its strengths. The compound annual growth rate formula determines a smoothed growth rate that ignores potential volatility. Unfortunately, a compound annual growth rate (CAGR) might occasionally give you an overstated compounded annual growth rate because the return on investments is typically uneven and doesn’t consider investors adding to or removing money from their portfolio.
Conclusion
CAGR is a beneficial formula for estimating investment growth rates. It can gauge future results on your assets or assess past returns. But keep in mind that CAGR is effective for lump-sum investing. This is because systematic Investment Plans (SIPs) do not account for recurring investments; instead, the calculation takes into account the initial value and end value. Nevertheless, the CAGR calculator is a beneficial tool that can assist you in analyzing your investments overall.