Compound Annual Growth Rate (CAGR) : Formula, Calculation & Uses

Last Updated : 03 Mar, 2024

What is CAGR?

The Compound Annual Growth Rate (CAGR) is a metric used to calculate the yearly rate of growth of an investment or company over a given period, assuming that the growth is constant. It gives a normalised annual rate of return and is especially useful for assessing the success of an investment or business over a long period.

In simple terms, the Compound yearly Growth Rate (CAGR) is a metric that describes the average yearly growth rate of an investment over a given period, presuming that the investment expands or decreases at a constant pace each year. It gives a smoothed, consistent rate of growth that, if applied annually, yields the same final value as the actual variable rate of growth.

Geeky Takeaways:

• The CAGR denotes the rate of compounded growth that an investment gets over a designated period.
• By incorporating the compounding effect, it shows a consistent indicator of growth.
• It is widely employed to compare the performance of various investments, and CAGR enables a standardised evaluation.
• A consistent metric is provided to assess the performance of investments, enabling straightforward comparisons.
• The CAGR is an exceptionally valuable metric for evaluating the performance of long-term investments due to its ability to reflect the mathematical advancement of returns.

How is CAGR Calculated?

CAGR necessitates three inputs, the initial and final values of the investment, as well as the period in years.

Example of Compound Annual Growth Rate (CAGR)

Let’s take an investment example for Company X,

Beginning Value (Initial Investment) = â‚¹5,000, Ending Value (Value after 3 years) = â‚¹7,500, The period is 3 years. The formula for calculating CAGR is,

CAGR = -0.793

Consequently, the CAGR computed for this particular example is roughly -79.3%. A decline in value is indicated by the negative sign throughout the three-year duration. Negative compound annual growth rates (CAGRs) indicate a decrease in the investment.

What Can CAGR Tell You?

Over a certain period, the Compound Annual Growth Rate (CAGR) can offer important insights into how a business or investment performs. Key information that CAGR can provide is as follows,

1. Annual Growth on Average: The compound annual growth rate (CAGR) of an investment over a given period is indicated. It provides a compounded, smoothed rate that, if used annually, would have the same final value.

2. Comparative Analysis: The CAGR makes it simple to compare the rates of growth of various assets or investments. It functions as a common metric for evaluating and contrasting the results of different investments made over the same period.

3. Long-Term Performance: When assessing long-term performance, CAGR is helpful. By reducing short-term swings, it aids investors in understanding how an investment has increased or decreased on an annualised basis.

4. Making Investment Decisions: CAGR is a tool that investors frequently use to assess past investment performance and make well-informed decisions regarding current and future investments. It offers a historical viewpoint that can help determine the likelihood of further expansion.

5. Goal Assessment: The CAGR can be used to determine if a particular investment has achieved its financial objectives. Investors can assess performance against expectations by contrasting the actual CAGR with desired rates.

6. Risk Evaluation: Although CAGR doesn’t precisely quantify risk, it can be used to infer the predictability of an investment’s growth. While a variable or negative CAGR may signal increased risk, a constant and positive CAGR suggests sustained growth.

Uses of CAGR

Beyond its fundamental utility in measuring investment growth, the Compound Annual Growth Rate (CAGR) has multiple other applications in various financial and business contexts. Here are some of the applications of CAGR,

1. Projecting Future Values: CAGR can be applied to project future values based on previous growth rates. By applying the estimated CAGR to the current value, one may predict the possible future worth of an investment or firm over a particular period. This estimate depends on the presumption that the previous rate of growth will persist.

2. Evaluating Investment Choices: CAGR is beneficial for evaluating the past performance of various investment choices. Buyers can use CAGR to determine whether the investment has generated a more consistent and appealing yearly return over a certain time range. This assists in making educated decisions on where to devote funding.

3. Evaluation of Sales and Earnings Increase: In the setting of businesses, CAGR can be utilised to measure the compound annual growth of sales, earnings, or other important performance indicators. This gives a consistent criterion to evaluate the entire growth trajectory of a company and aids in performance benchmarking.

4. Defining Realistic Financial Aims: CAGR can help in defining realistic financial aims for future periods. By analysing past growth rates, firms and investors can define reasonable goals for revenue, earnings, or other financial measures. It gives a quantitative framework for setting objectives that consider past success.

5. Examining Sector or Industry Performance: CAGR is beneficial for examining the past performance of entire sectors or industries. CAGR allows investors and analysts to analyse the normal growth rates of different sectors over a certain period, assisting them in identifying trends, opportunities, and areas of concern in the broader market.

How do Investors Use CAGR?

Understanding the technique used to compute CAGR provides an introduction to many different methods that investors use to evaluate previous returns or forecast future profits. The formula can be algebraically adjusted to find the present or future value of money or to compute a hurdle rate of return.

Assume an investor understands they will need â‚¹50,000 for their child’s higher education in 18 years and have â‚¹15,000 to invest today. What is the required average rate of return to achieve that goal? This question can be answered using the CAGR calculation, as follows,

This CAGR formula is simply a rearrangement of present value and future value equation. For example, if an investor knew they needed â‚¹50,000 and believed it was reasonable to expect an annual return of 8%, they could use this method to determine how much they needed to invest to accomplish their objective.

Modifying the CAGR Formula

An investment is rarely made on January 1st and then sold on December 31st. Consider an investor who wishes to calculate the CAGR of a â‚¹10,000 investment made on June 1, 2018, and sold for â‚¹16,897.14 on September 9, 2023. Before performing the CAGR calculation, the investor must first determine the fractional remaining of the holding period. In 2018, they held the title for 213 days, an entire year in 2019, 2020, 2021, and 2022, and 251 days in 2023. This investment was kept for 5.271 years, as determined by the following formula,

Year

No. of Days

2013

213 days

2014

365

2015

365

2016

365

2017

365

2018

251

The investment was held for a total of 1,924 days. Divide the total number of days by 365 to get the number of years, which is . The total number of years the investment was held can be entered into the denominator of the exponent within the CAGR formula as follows:

What is Considered a Good CAGR?

The definition of a “good” Compound Annual Growth Rate (CAGR) might differ based on the environment, industry, and the particular objectives and expectations of investors. An ideal Compound Annual Growth Rate (CAGR) surpasses the inflation rate and fulfills or beyond the investor’s desired return. When assessing the quality of a compound annual growth rate (CAGR), there are several factors to take into account,

1. Comparative Analysis: CAGR gains significance when it is compared to other benchmarks or assets that are comparable. A better perspective can be gained by comparing the compound annual growth rate (CAGR) of an investment with relevant market indices, industry averages, or the cost of capital.

2. Risk Tolerance: Investors possess varying levels of risk tolerance, so that a satisfactory Compound Annual Growth Rate (CAGR) for one investor may not meet the standards of another. A higher compound annual growth rate (CAGR) is typically accompanied by increased volatility and risk. Therefore, it is essential to evaluate if the level of risk is in line with the investor’s risk tolerance.

3. Investment Horizon: The suitable Compound Annual Growth Rate (CAGR) is contingent upon the duration of the investment. A lower Compound Annual Growth Rate (CAGR) may be deemed acceptable for long-term investments, provided that it remains steady and sustainable over an extended period. Short-term investments may necessitate a greater Compound Annual Growth Rate (CAGR) to achieve specific financial objectives.

4. Market Conditions: Economic and market conditions have the potential to impact the definition of a favourable Compound Annual Growth Rate (CAGR). During moments of economic prosperity, it may be relatively easier to achieve higher growth rates, but during economic downturns, achieving a high compound annual growth rate (CAGR) may prove to be more difficult.

5. Investment Type: Various investments display distinct risk-return characteristics. A cautious investment, such as government bonds, may have a lower “good” compound annual growth rate (CAGR) compared to a riskier investment, such as equities.

6. Inflation Adjustment: It is crucial to take into account the influence of inflation on the real rate of return. A Compound Annual Growth Rate (CAGR) that surpasses the inflation rate is generally regarded as favorable in terms of actual wealth expansion.

7. Investment Plan: The investor’s investment plan and objectives have a substantial impact. Certain investors place more value on safeguarding their capital and achieving consistent returns, whereas others may prefer ambitious growth and are willing to suffer greater fluctuations to get better returns.

The assessment of a satisfactory Compound Annual Growth Rate (CAGR) is ultimately subjective and relies on the individual circumstances of the investor and the investment. Investors must prioritise establishing clear objectives, understanding their risk tolerance, and assessing the Compound Annual Growth Rate (CAGR) within the wider framework of their investment approach.

Limitations of CAGR

The Compound Annual Growth Rate (CAGR) is a common way to measure growth in the business world. It gives a smoothed annual rate of growth over a certain amount of time. CAGR is a good way to look at the returns on investments or the success of a business, but it does have some flaws. Here are some things to think about,

1. Assumption of Constant Growth: CAGR assumes that the rate of growth will stay the same over the whole time, which might not always be the case. Growth rates can change from year to year, so CAGR may not be the best way to look at things.

2. Sensitive to Outliers: CAGR can be affected by data points that are outliers or have very high or very low numbers. It is possible for CAGR to not accurately show the overall growth if the values change a lot over periodnecessitatestime.

3. Ignores Timing and Volatility: CAGR doesn’t look at when gains will come in or how volatile the investment is. It treats every year the same and doesn’t take market ups and downs into account.

4. Doesn’t Take Risk into Account: CAGR doesn’t take risk or the fact that returns can change into account. Different investments with the same CAGR may have different amounts of risk, and CAGR may not tell you everything you need to know about how an investment is doing.

5. Single-Point Metric: The compound annual growth rate (CAGR) is a single-point metric that shows growth over a certain time frame. It doesn’t say anything about the steps the investment took to grow that much. A high CAGR investment may have gone through a lot of ups and downs along the way.

Difference Between CAGR and IRR

Basis

Compound Annual Growth Rate (CAGR)

Internal Rate of Return (IRR)

PurposeCAGR is usually used to show an investment’s average yearly growth rate over a given time period. It is a consistent rate that generates the same final value.IRR is used to assess an investment’s profitability by calculating the discount rate that compares the present value of cash inflows with the present value of cash outflows.
AssumptionCAGR necessitate a constant rate of growth over the entire periodassumes, which may not accurately reflect the year-to-year shift in growth rates.IRR makes the assumption that cash flows will be reinvested at the calculated IRR, which isn’t necessarily realistic or feasible in real-life circumstances.
ApplicationCAGR is frequently used to evaluate average annual growth, compare the past performance of assets, and establish performance benchmarks.IRR is frequently used to determine capital budgeting, evaluate projects, and determine an investment’s internal profitability.
Handling Multiple RatesThe compound annual growth rate (CAGR) is a single rate that indicates the average annual growth. It cannot manage multiple rates of return or changes in the cash flow direction of the investment.IRR can handle numerous rates of return, including cash flow direction changes (negative to positive and vice versa).

Conclusion

Even though CAGR is a useful tool, it is important to know what it can’t do, like assuming constant growth and being easily fooled by outliers. Additionally, CAGR should be used along with other financial measurements and factors to fully comprehend how well an investment or business is growing. As with any business evaluation, it gives a useful picture of past success. However, to make smart decisions, you need to look at the big picture and think about many things, such as risk, market conditions, and the outlook for the future.

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