Compound Annual Growth Rate (CAGR)

by Mansi Singhal
reasons to invest in Mutual Funds

Compound Annual Growth Rate (CAGR) can be defined as the rate of annual growth of the investment over a specific period. It is the measure of how much a person can be earned on his/her investment in a given time interval. It is one of the most common methods of calculating the ups and downs in the investment return.

CAGR is used to compare more than one investment to evaluate how well one stock will perform against the other stock and choose the one which yields a higher return but does not reflect the investment risk.

How to calculate CAGR?

The Compound Annual Growth Rate (CAGR) can be calculated by using the below-mentioned formula as:-

CAGR = (Ending balance/beginning balance) 1/n – 1

Where,

  • Ending balance = the value of the investment at the end of the investment period
  • Beginning balance = the value of the investment at the beginning of the investment period
  • N = the number of years you have invested

To calculate the CAGR of investment, the following steps are to be followed:-

  1. Divide the ending balance of an investment by its beginning value.
  2. Raise the result to an exponent of one divided by the number of years (n)
  3. Subtract one from the respective value. 

Example of how to use CAGR

Let us assume that Mr. A has invested Rs. 20,000 in a portfolio with the return mentioned below as:-

  • From January 1, 2016, to December 31, 2016, his portfolio was grown by 10%
  • From January 1, 2017, to December 31, 2017, his portfolio was grown by 6%. 27,8
  • On January 1, 2018, his portfolio was grown by 17%.

In the example, we can see that growth rates of the investment portfolio were quite different.

CAGR = (27,284.4 / 10,000) 1/3   – 1 = 10.9%

The CAGR of 10.9% over the three years can Mr. A compare alternatives for his capital or help in decision-making also. Let u say that, He is comparing the performance of two investments that are not related to each other in any aspect. In a given period, one investment may be rising and vice-versa.  It would be a case of comparing ETFs and mutual funds. So, CAGR will be made it easier to compare two investments over a while.

Additional CAGR Uses

  • Compare Investment – CAGR can be used to compare alternative investments over a specific time period. For example- suppose Mrs. Anita, an investor placed Rs 10,000 into an account for 10 years with a fixed annual interest rate of 1% and Rs 10,000 into the mutual fund.

Assume that at the end of the ten years, the saving account balance is Rs 20,000, and the ending balance of stock is Rs 15,000. Using CAGR to compare two different investment can help an investor understand the difference in return as:

Saving Account CAGR = ( 20,000 / 10,000) 1/10 – 1

                                        = 7.1%

Stock Fund CAGR = (15,000 / 10,000) 1/10   – 1

                                  = 4.1 %

Here, the stock may look like a better investment option, because it gives nearly 4 times the return as compare to saving account. But the main drawback here is that by smoothening the returns, CAGR cannot tell an investor how volatile the stock fund was.  

  • Track Performance – CAGR can be used to track the performance of various business units of one or more companies. For example, over a two-year period, Big Sale Store’s market share CAGR was 1.56%, but its customer satisfaction over the same period was -0.58% which was very low. In this way, it will compare the strengths and weaknesses of any company.

  • Strength & Weakness – CAGR tells the performance of the companies and helps to analyze the strength and weakness of its business unit, i.e, where its operations are lacking and the company cost is higher. It denotes whether the invested amount can generate any return or not.

Things to know about CAGR

There are some of the most important things one should know about the Compound Annual Growth Rate –

  • It is generally considered a more effective and accurate tool for measuring the growth rate of an investment.
  • While comparing the CAGR of more than one investment, make sure that the duration of the investment period is the same.
  • CAGR is generally calculated between a time frame of 3 years to 7 years.
  • It never considered the risk level of investment because it assumes the constant rate of return.           

Advantages of CAGR

#1 Accurate Tool:

The Compound Annual Growth Rate (CAGR) is a useful and effective tool for comparing the alternative options of an investment over a period and allows an investor to choose one option on an investment by analyzing the growth rate, the risk involved, liquidity, diversification, and time horizon include in it. One of CAGR’s advantages over other investments is that it is not influenced by percentage change with the investment horizon.

#2 Used for Comparison:

CAGR is used to name better decisions among various options an investment say mutual fund or stock or real estate or bonds etc. It measures the annual growth rate of the investment and compares it with other options. It is also beneficial because it also tells the downfall in the investment over a period of time.

#3 Estimate future returns:

CAGR is useful to estimate the future return of investment by assuming certain assumptions by carefully analyzing the historical investment data and past events. Although it compares the past and future rate of return on the investment to ensure the profitability and inflation rate during the tenure of the investment.

Disadvantages of CAGR

#1 Smoothing and Risk:

Compound Annual Growth Rate (CAGR) assume growth rate to be constant throughout the investment period which made it highly volatile in the market. CAGR can be used to take a quick decision among several investments, but any decision should be taken after analyzing the risk involved in the investment.

#2 Investors Action:

Another disadvantage of CAGR is that it does not take into consideration the change in the investment value caused by various reasons which might be withdrawal of amount, the scope of diversification, liquidity ratio of the investment, etc.

What does the CAGR tell you?

Compound Annual Growth Rate (CAGR) is the rate of return at which an investment grows in the given time, by assuming that the profits are reinvested every year in the initial amount of the investment.

CAGR tells the rate at which an investment can rise or fall. It is an average return on the investment over a specific time. One can use the compound annual growth rate to compare the returns from different investments.

CAGR doesn’t give a true return on an investment but a representational number. An investment generally cannot grow at the same return every year because the profits are reinvested each time. However, CAGR is used to compare the alternative investment and not a single investment.

What is a good CAGR percentage?

Compound Annual Growth Rate (CAGR) show by what percentage the investment grew over a specific period. It is considered as one of the effective tools for calculating return on investment.

There is no definite or fixed percentage for a CAGR when it comes to an equity investment because it is a combination of many factors such as the amount of investment, time of investment, rate of I, etc. It is advised that CAGR should be more than saving account interest rate otherwise, a saving account is much better than other forms of investment.

In the long run, large and small companies have given a return between 8% to 12% to their shareholders as a dividend. On the other hand, small and mid-cap companies have a great potential to earn a higher return and highly liquid than another form of investment.

Is CAGR a good measure?

Yes, CAGR is considered a good and accurate tool for measuring the rate of return on investment. It is the most effective way of calculating historical returns. It takes the beginning and ending value of the investment and calculates return based on the time.

Also, it is used to compare the performance of different investment options such as equity, bond, real estate, or derivatives. Since the return is smoothened and an investor can compare it with an alternative investment option. It forms the basis of all future projections.

However, CAGR has some disadvantages too as it ignores the cash flow and cash outflow that happens on the investment. It also takes into consideration the constant rate of return on investment. It only takes into consideration the beginning and ending value of an investment. Moreover, it takes a constant rate of return during an investment time. 

What is the difference between CAGR and growth rate?

Compound Annual Growth Rate (CAGR) means the rate of return of the investment that grows every year over a specific period. In other words, it tells the growth and falls in the return of investment. Investors can use the CAGR tool to compare alternative investments.

Whereas, Growth Rate is a measure of the percentage increase of a given metric over a given time. It can be calculated by subtracting the current value from the previous value. The result is divided by the previous value and then multiply by a hundred. This gives a percentage representation of the growth rate.

Growth Rate = (Current Value – Previous Value) / Previous Value x 100

CAGR is the actual growth rate on an investment over a specific time, on the other hand, the growth rate is a percentage increase over some time. Usually, growth rates, are used to study population size, demographics ratio, economic activity, income growth, etc. It is a variation of growth rate, which is used to analyze the investment performance.

What is the difference between CAGR vs IRR?

The CAGR measures the return on an investment over a particular period. The Internal Rate of Return (IRR) also measures investment performance while CAGR is easier to calculate and IRR is quite complicated in some situations.

The most important difference between both of them, CAGR is straightforward enough that it does not need much calculation and is calculated by hand also, but IRR is used for more complex and complicated investments and projects. So, IRR is a financial calculator, excel portfolio accounting system.

Conclusion

CAGR is a very useful and effective way of calculating the annual rate of return on investment. It can be used to evaluate both past returns and estimate the future return on investment. But it should be kept in mind that CAGR, will applicable on lump sum investments. Overall, the CAGR calculator is a very useful tool to analyze an investment and yield the rate of return in the investor’s portfolio.

Frequently Asked Questions

1. How do we calculate CAGR?

To calculate the CAGR of an investment – Divide the ending value of an investment at the end of the period by its beginning value of that period. Then, result to an exponent of one divided by the number of years. Subtract the respective result from one.

2. What does 3 years CAGR mean?

The sales 3-year Compound Annual Growth Rate measures the growth rate in sales over the long run in past three years.

3. Can CAGR be negative?

There is the possibility of negative CAGR, is a person wants to have a negative growth rate, but it does not make any sense because the profit on the investment will be deposit in the initial investment amount which make the CAGR percentage positive.

4. Is CAGR same as the IRR?

The CAGR calculates the return on investment over a certain time whereas, the Internal Rate of Return (IRR) also measures the performance of an investment. Besides it, CAGR is easier to calculate, IRR is quite complicated as compared to CAGR.

5. What does negative CAGR mean?

Negative CAGR means that an investment value is declining from time to time, it happens when the ending value is lower than the beginning value of an investment. It is always advisable to have a positive CAGR otherwise your investment portfolio is not able to generate an adequate return and it will incur expenses to you.

6. What does the CAGR tell you?

CAGR tells the growth or fall in the investment over a while and helps in decision-making in the case of alternative investment options.

7.   Is CAGR a percentage?

The Compound Annual Growth Rate (CAGR) shows the rate of return on investment for a certain time and is expressed in percentage terms.

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