What Is Compound Annual Growth Rate and How To Calculate It CAGR is a critical metric for business owners and investors who want their ventures to excel. This article explains what CAGR means and other details.
Compound annual growth rate (CAGR) measures the overall investment return over a period of time. To calculate it, you must know the beginning value, end value (or ending balance), and the number of years between.
This article will take a closer look at CAGR and how to calculate it so that you can make sound financial decisions.
Related: How To Start Investing
Compound annual growth rate (CAGR) meaning
CAGR stands for "compound annual growth rate," and it is used to measure the performance of stocks, bonds, mutual funds, and other investments. It's also a useful tool for comparing the relative performance of different investments.
A higher CAGR indicates a better return on investment, while a lower CAGR implies a worse return on investment. You should consider the expected CAGR and the risks associated with an investment before making any investment decisions.
The CAGR formula
The CAGR formula is fairly straightforward:
CAGR = ((Ending value/beginning value)1/number of years in investment period- 1)
You can multiple your final number by 100 to put it into a percentage versus a decimal.
So, for example, if you invested $10,000 in a stock that is now worth $15,000 after five years, you'd divide 15,000 by 10,000, then raise that to the power of 1 divided by 5, then subtract that by 1.
That looks like this: ((15000)/10000)^(1/5)) - 1 = 0.08447 = about 8.4 percent.
You can also use an online CAGR calculator to do the math. Simply enter the starting value, the ending value, and the number of years, and you'll end up with the CAGR percentage.
6 examples of how to use CAGR
CAGR is the mean annual growth rate of an investment over a specified period of time longer than one year. Many use CAGR when analyzing investments that pay periodic returns, such as publicly traded companies, mutual funds, and bonds.
The advantage of using CAGR over other return measures, such as total return or simple average, is that it smooths out the effects of sporadic positive or negative performance over the investment's holding period.
This makes it a valuable metric for determining the value of an investment and comparing the performance of different investments.
Here are six examples of how you can use CAGR:
1. To compare the performance of different investments
CAGR can be used to compare the performance of different investments over time.
For example, if you're considering investing in two different stocks, you can use CAGR to see which stock has outperformed the other over the past five years.
While it's not the only important metric, the CAGR will give you a strong indicator if a given investment is sound.
2. To measure the growth of a company
You can use CAGR to measure the compound growth of a company over time. For instance, it can show you how your company's revenue has grown over the past decade. This can help you make comparisons and see how your company is growing in relation to others.
3. To estimate future growth
CAGR can be used to estimate future growth rates. Say that you know a company has averaged 10 percent annual growth over the past five years; the CAGR may estimate it to grow at a similar rate in the future.
4. To compare different time periods
You can implement CAGR to compare different periods.
For instance, you could use CAGR to see how a company's revenue has grown from one year to the next or from one decade to the next. This can help you make crucial decisions in various areas down the road.
5. To account for compounding
One advantage of using CAGR is that it factors in compounding. When using other return measures (such as simple average), it's easy to forget about compounding (i.e., how gains on an investment are reinvested and earn additional returns over time).
However, because CAGR takes compounding into account, it can provide a more accurate picture of an investment's average return.
6. To benchmark against an index
Finally, CAGR can be used to benchmark an investment's performance against a relevant market index.
To determine whether a stock pick has outperformed the S&P 500 Index, you would calculate each security's compound annual growth rate and compare it to the S&P 500's CAGR over the same period. If the stock pick's CAGR is higher than that of the S&P 500 Index, it has outperformed; otherwise, it has underperformed.
8 benefits of using CAGR
While CAGR is most often used to track the growth of stocks and mutual funds, you can also measure the growth of other investments like bonds and real estate.
CAGR has many advantages over other growth measures, such as the simple return on investment (ROI). Here are eight benefits of using CAGR:
1. CAGR smooths out volatility
When you look at the ROI of an investment over a short period, it can be highly volatile. This is because there are inevitable ups and downs in the markets.
But when you use CAGR to track the performance of an investment over a more extended period, you smooth out this volatility and get a more accurate picture of the underlying growth rate.
2. CAGR is easy to calculate
All you need to do to calculate CAGR is to find the beginning value and ending value of your investment and then divide them by the number of years that have elapsed.
Working with numbers as an investor can be challenging, especially with how many metrics and formulas there are to know (and understand). CAGR is one of the most straightforward ROI measurements available.
3. CAGR is easy to understand
Unlike other measures of growth, such as the internal rate of return (IRR), CAGR is relatively easy to understand and interpret. Reading an article (like this one), plugging your numbers into a calculator, or conversing with your financial advisor is all it really takes.
4. CAGR is flexible
You can use CAGR to track the performance of investments over any period that you choose. For example, you could use it to track the performance of a stock over one year, five years, or 10 years. Or, you could use it to compare the performance of two investments over different periods.
5. CAGR can be applied across different asset classes
Unlike some other growth measures (like price-earnings ratios, aka P/E ratios), CAGR can be applied to various asset classes. This makes it more versatile and functional for investors, which is why many investors use it. You can use CAGR for stocks, mutual funds, and other investments like bonds, real estate, and commodities.
6. CAGR takes into account changes in value
When calculating ROI, you assume that the value of your investment remains constant over time. In reality, investments usually increase or decrease in value as the months and years pass. CAGR considers these changes in value, making it a more accurate measure of growth.
7. CAGRs can be compared side-by-side
When two investments have different starting and ending values, it can be challenging to compare their performance using traditional measures of ROI. With CAGRs, you can easily compare the performance of two investments side-by-side regardless of their starting values.
8. CAGR can be a good measure of long-term performance
Investors typically use CAGR to measure the performance of investments over a three-year or five-year period, but you can also use it to track the performance of an investment over more extended time frames. CAGR can help measure investment risk and long-term growth (or decline) if you don't use it in isolation.
Overall, CAGR is an effective tool for tracking the performance of investments over time. It can provide a more accurate picture of growth than traditional measures, is easy to calculate and understand, and can be used across various asset classes.
Considering these benefits, it's no wonder why CAGR is such a popular measure of investment performance. There aren't many significant drawbacks to incorporating them into your investment decision-making process.
Are there any limitations of using CAGR?
First, CAGR only measures the rate of growth over a specific period, so it doesn't provide any information about an investment's current value, future values, or its past performance and historical returns. This means that investors should be careful not to exclusively use CAGR to evaluate the performance of an investment over a long period.
Second, CAGR only considers linear growth; it doesn't consider any sudden fluctuations in value that may have occurred during the measured period. As such, it can produce distorted results if there are significant changes in value during the time frame in question. The better measurement to use in that instance would be total return, which factors in all types of growth (including sudden fluctuations in value).
Third, CAGR doesn't account for variability in an investment's growth rate; for example, if an asset has grown at a 10 percent CAGR over the past five years, but its growth rate has been declining each year, the actual average growth rate may be lower than 10 percent. It's easy to see how missing that measurement could skew your decision-making and yield serious problems.
It's also worth noting that CAGR can be misleading when applied to investments with different starting and ending values. The problem is that CAGR doesn't consider the actual performance of the assets; it only looks at their growth rate.
Finally, CAGR doesn't consider the effects of inflation, taxes, or other factors that can affect an investment's actual return. And when you live in an inflationary economy, that's a big deal.
For all these reasons, CAGR should be used cautiously and only as one piece of information when evaluating an investment.
How is CAGR different from growth rate?
While both CAGR and growth rate measure an investment's performance, they do so in different ways and can produce different results.
The CAGR can be a more accurate measure of an investment's performance than some alternatives because it factors in the effect of compounding.
The growth rate does not consider the impact of compounding and can therefore give a misleading picture of an investment's performance.
The growth rate is also sometimes less reliable than the CAGR because small changes can influence the beginning or end values.
Ready to calculate CAGR?
The compound annual growth rate is an important metric to understand and use when measuring the success of your business.
By understanding how to calculate CAGR and using it in your analysis, you can make more informed decisions about where to allocate your resources to achieve the greatest return on investment.
Keep in mind the benefits and limitations of CAGR as you seek to diversify your investment portfolio or grow your business.
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