In finance, CAGR stands for compound annual growth rate. It is a method for calculating an investment’s annual growth rate over time while considering compounding. Businesses use it frequently to evaluate and compare an investment’s past performance or to project its expected future returns. If you want to calculate it, you’ll need to know the beginning value, ending value (or ending balance), and the number of years between them.
CAGR Meaning
In finance, the compound annual growth rate (CAGR) is one of the most accurate ways to calculate and estimate returns for anything whose value can rise or fall over time. The use of the compound annual growth rate facilitates comparing different investments over a comparable investment horizon. Higher CAGRs indicate more favorable investment returns, whereas lower CAGRs indicate more unfavorable returns. You should weigh the potential CAGR and investment risks before making any decisions about investments.
The fact that CAGR is unaffected by percentage changes within the investment horizon, which could lead to false results, is one of its advantages over an average annualized rate of return. Because it assumes constant growth over the investment’s time horizon, the compound annual growth rate has the disadvantage of being unreliable. This smoothing mechanism might produce unreliable results when used with an extremely volatile investment.
It shows your investments’ typical annual rate of return. CAGR is a useful tool for investors because it can accurately assess the growth (or decline) of investments over time. The compound annual growth rate, which assumes growth occurs at an exponential compounding rate, is the annualized average rate of revenue growth between two specified years.
Uses of Compound Annual Growth Rate
#1. Track Performance
The performance of various financial indicators for one or more businesses can also be monitored using the compound annual growth rate.
#2. To Estimate Future Growth
It is possible to predict future growth rates using a compound annual growth rate. If you are aware that a company has grown at an average rate of 10% annually over the previous five years, the CAGR may predict future growth at a similar rate.
#3. To Take Compounding Into Account
Utilizing CAGR has the benefit of accounting for compounding. It’s simple to overlook compounding when using other return measures (like the simple average), which refers to the process by which investment gains are reinvested to generate further returns over time.
#4. Measuring a Company’s Expansion
The compound annual growth rate can be used to calculate the compound annual growth rate of a business. It might be able to demonstrate the expansion of revenue for your business over the previous ten years, for example. You can use this to compare businesses and see how yours is developing in light of the competition.
#5. Look for Strengths and Weaknesses
It will be possible to assess the competitive advantages and disadvantages of different companies by comparing the CAGRs of their business activities.
Limitations of Compound Annual Growth Rate
#1. Consistent Rate of Growth
The main drawback of the compound annual growth rate is that it ignores volatility by calculating a smoothed rate of growth over a period, which implies that growth occurred steadily during that period. Investment returns are erratic over time, except for bonds that are held until maturity, deposits, and other comparable investments. Additionally, the CAGR does not take into account an investor’s additions to or withdrawals from a portfolio during the measurement period.
#2. CAGR only Calculates the Growth Rate Over a Specific Period.
It doesn’t offer any details regarding the present value, potential future value, past performance, or historical returns of an investment. As a result, investors should be cautious about relying solely on compound annual growth rates to assess the performance of an investment over an extended period.
#3. CAGR only Takes Into Account Linear Growth
It doesn’t take into account any abrupt changes in value that might have happened during the measurement period. As a result, if there are substantial changes in value throughout the study period, it may result in distorted results. Total return would be a better metric to use in that situation since it takes all forms of growth (including sudden changes in value) into account.
#4. CAGR Does Not Take Into Account the Fluctuation in an Investment’s Growth Rate
It’s also important to keep in mind that compound annual growth rates can be deceptive when used to compare investments with various starting and ending values. The issue is that CAGR only examines the assets’ growth rate; it ignores their actual performance. If an asset has had a five-year CAGR of 10% while also experiencing declining annual growth rates, the actual average growth rate may be less than 10%. It is simple to understand how omitting that measurement could skew your judgment and lead to serious issues.
#5. CAGR Does Not Account for Factors Such as Taxes, Inflation, and Other Factors
A second drawback is that investors cannot assume that the rate of growth will remain constant in the future, regardless of how steadily a business or investment has grown in the past. When using historical data, there is less chance that the realized CAGR will match the expected compound annual growth rate the shorter the period used in the analysis.
Benefits of Using CAGR
#1. CAGR Smooths Out Volatility
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. Because 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
#2. Calculating CAGR is Simple
Finding the starting and ending values of your investment and dividing them by the number of years that have passed will allow you to calculate CAGR. One of the easiest ways to calculate ROI is through a compound annual growth rate.
#3. CAGR is Simple to Comprehend
CAGR is more straightforward to comprehend and interpret than other growth indicators, such as the internal rate of return (IRR). The only real requirements are reading an article (like this one), entering your data into a calculator, or speaking with your financial advisor.
#4. CAGR is Flexible
compound annual growth rate can be used to monitor investment performance over virtually any time frame. You could, for instance, use it to monitor a stock’s progress for one, five, or ten years. As another option, you could use it to contrast the performance of two investments over various time frames.
#5. CAGR Considers Variations in Value
You assume that your investment’s value will remain constant over time when calculating ROI. In actuality, investments frequently gain or lose value for months and years. CAGR is a better indicator of growth because it takes these value changes into account.
#6. It Is a Useful Metric for Assessing Long-Term Performance
CAGR is frequently used by investors to gauge the performance of investments over three or five years, but it can also be used to monitor an investment’s performance over longer periods. If you don’t use CAGR alone, it can be a useful tool for assessing long-term growth (or decline) and investment risk.
CAGR Meaning Finance
Instead of representing a true return rate, the compound annual growth rate is a representative number. It is essentially a number that expresses the rate of growth an investment would have experienced if it had grown at the same rate each year and had its profits been reinvested at year’s end. In finance, The compound annual growth rate can be used, as opposed to other methods, to smooth returns and make them simpler to comprehend. The annualized average rate of revenue growth between two specified years is known as the compound annual growth rate (CAGR), assuming that growth occurs at an exponential compounding rate.
CAGR Formula
These details are all that is required to determine the compound annual growth rate, along with the investment’s starting value, ending value, and number of compounding years. To do this, divide the ending value by the starting value, raise the result to the inverse number of years, and then subtract one.
The CAGR formula is as follows:
CAGR = (FV / PV) ^ (1 / n) – 1
where:
EV=Ending value
BV=Beginning value
n=Number of years
To determine an investment’s CAGR:
- A period’s value is calculated by dividing the investment’s value at the start of the period by its value at the end.
- The result should be multiplied by one and divided by the number of years.
- From the final result, deduct one.
- The solution will become a percentage when multiplied by 100.
Example
Let’s say an investor bought 100 shares of Amazon.com (AMZN) stock in December 2020 at $950 per share, for a total investment of $95,000. After two years, in December 2022, the stock has risen to $2,500 per share, and the investor’s investment is now worth $250,000.
Using the CAGR formula, we know that we need the:
Ending Balance: $250,000
Beginning Balance: $95,000
Number of Years: 2
So to calculate the CAGR for this simple example, we would enter that data into the formula as follows: [($250,000 / $95,000) ^ (1/2)] – 1 = 62%.
Example 2
The initial value of your investment is $24,000, and the final value is $33,000 in five years (N= 5 years). It is calculated as:
CAGR = (33,000/24,000)^(⅕) – 1
The CAGR = 6.6%.
CAGR vs Growth Rate
Although compound annual growth rate and growth rate are both used to gauge an investment’s performance, their methods differ and the outcomes they can yield can vary. The main distinction between a growth rate and a CAGR is that the former presumes that the growth rate was repeated or “compounded” annually, whereas the latter does not. Since the CAGR smooths out the erratic nature of annual growth rates, it is preferred by many investors.
Considering the effect of compounding, the CAGR may be a more accurate indicator of an investment’s performance than some other metrics.
The growth rate does not take the effects of compounding into account, which can lead to a false impression of an investment’s performance. The growth rate can occasionally be less dependable than the CAGR because minor adjustments can change the values at the start or end.
What Does CAGR Tell You?
The compound annual growth rate is the average annual growth rate of an investment over a given period longer than one year. It stands for one of the most precise methods for figuring out returns for particular assets, investment portfolios, and anything else that can increase or decrease in value over time. Compounded annual growth rate (CAGR) is a metric for comparing the profitability of various types of businesses that shows the cumulative performance of a specific variable over a long period.
What CAGR Is Considered Good?
The definition of a good CAGR will vary depending on the situation. Investors will typically assess this by taking into account both the investment’s risk and their own opportunity cost. The better option is typically a higher CAGR.
Can the CAGR Be Negative?
Yes. A negative CAGR would represent long-term losses as opposed to gains.
Is a CAGR of 5% good?
The significance of a high CAGR percentage will depend on the type of investment you have made. In the case of stocks, you are doing well if your portfolio is expanding at a CAGR of 18–25%.
Is a CAGR of 20% good?
There is no clear definition of what a good CAGR is because CAGR evaluates an investment’s performance. Depending on the investment’s volatility and risk, a good CAGR could be anywhere between a few percent and 20–30%.
What’s the Difference Between Cagr and Annualized Return?
CAGR is another name for an annualized return. The fluctuations in an investment’s return over time are smoothed out by it. It is a helpful tool for contrasting investments that have generated various returns over a range of periods.
Annualized returns It is the geometric mean of the amount of money an investment generates on average annually over a set period. Annualized returns represent the rate of return an investor earns over a specific time frame while taking annual compounding into account. Without concentrating on market volatility, this gives clarity as to how the investment would behave.
Annualized Return is calculated as follows: (End Value – Beginning Value) / (Beginning Value) x 100 x (1/holding period of the investment).
An annualized return is a return that has been extrapolated over the entire year. CAGR displays the typical annual growth of your investments.
Conclusion
The phrase “compound annual growth rate” (CAGR) is only used in the context of business and investing to describe a geometric progression ratio that provides a constant rate of return over time. CAGR is thus a useful metric for assessing the performance of various investments over time or in comparison to a benchmark. But investment risk is not reflected in the CAGR.
In general, CAGR is a useful tool for monitoring the progress of investments over time. CAGR should be used with caution and only as one piece of information when evaluating an investment because it can give a more accurate picture of growth than traditional measures is simple to calculate and understand, and can be applied to different asset classes.
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