Table of Contents
Definition CAGR
Compound annual growth rate (CAGR) is the rate of return that would be required for an investment to grow from its beginning balance to its ending balance, assuming the profits were reinvested at the end of each year of the investment’s lifespan.
Formula and Calculation of CAGR
\begin{aligned} &CAGR= \left ( \frac{EV}{BV} \right ) ^{\frac{1}{n}}-1\\ &\textbf{where:}\\ &EV = \text{Ending value}\\ &BV = \text{Beginning value}\\ &n = \text{Number of years} \end{aligned}CAGR=(BVEV)n1−1where:EV=Ending valueBV=Beginning valuen=Number of years
To calculate the CAGR of an investment:
- Divide the value of an investment at the end of the period by its value at the beginning of that period.
- Raise the result to an exponent of one divided by the number of years.
- Subtract one from the subsequent result.
What CAGR Can Tell You
The compound annual growth rate isn’t an actual return rate but rather a symbolic figure. It is essentially a number that describes the rate at which an investment would have grown if it had grown the same rate every year and the profits were reinvested at the end of each year.
In reality, this sort of performance is unlikely. However, CAGR can be used to smooth returns to be more easily understood compared to alternative investments.
Example of How to Use CAGR
Imagine you invested $10,000 in a portfolio with the returns outlined below:
- Firstly from Jan 1, 2014, to Jan 1, 2015, your portfolio grew to $13,000 (or 30% in year one).
- On Jan 1, 2016, the portfolio was $14,000 (or 7.69% from Jan 2015 to Jan 2016).
- On Jan 1, 2017, the portfolio ended with $19,000 (or 35.71% from Jan 2016 to Jan 2017).
We can see that the year-to-year growth rates of the investment portfolio were quite different on an annual basis, as shown in the parenthesis.
On the other hand, the compound annual growth rate smooths the investment’s performance and ignores the fact that 2014 and 2016 were different from 2015. The CAGR over that period was 23.86% and can be calculated as follows:
CAGR=\left(\frac{\$19,000}{\$10,000}\right )^{\frac{1}{3}}-1=23.86\%
CAGR=($10,000$19,000)31−1=23.86%
The compound annual growth rate of 23.86% over the three-year investment period can help investors compare alternatives for their capital or make forecasts of future values. For example, imagine an investor is comparing the performance of two uncorrelated investments.
In any given year during the period, one investment may be rising while the other falls. When comparing high-yield bonds to stocks or a real estate investment to emerging markets, it could be the case. Using CAGR would smooth the annual return over the period, so the two alternatives would be easier to compare.
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Additional CAGR Uses
The compound annual growth rate can be used to calculate the average growth of a single investment. As we saw in our example above, due to market volatility, the year-to-year growth of an investment will likely appear erratic and uneven.
For example, an asset may increase in value by 8% in one year, decrease in value by -2% the following year and increase in value by 5% in the next.
CAGR helps smooth returns when growth rates are expected to be volatile and inconsistent.
Compare Investments
CAGR can be used to compare investments of different types with one another. For example, suppose in 2013, an investor placed $10,000 into an account for five years.
with a fixed annual interest rate of 1% and another $10,000 into a stock mutual fund.
The rate of return in the stock fund will be uneven over the next few years, so a comparison between the two investments would be difficult.
Assume that at the end of the five years, the savings account’s balance is $10,510.10 and, although the other investment has grown unevenly, the ending balance in the stock fund was $15,348.52.
Using CAGR to compare the two investments can help an investor understand the difference in returns:
\text{Savings Account CAGR} =\, \left ( \frac{\$ 10,510.10}{\$ 10,000} \right )^{\frac{1}{5}}-1 = 1.00\%Savings Account CAGR=($10,000$10,510.10)51−1=1.00%
And:
\text{Stock fund CAGR} =\, \left ( \frac{\$ 15,348.52}{\$ 10,000} \right )^{\frac{1}{5}}-1 = 8.95\%Stock fund CAGR=($10,000$15,348.52)51−1=8.95%
On the surface, the stock fund may look like a better investment with nearly nine times the return of the savings account.
On the other hand, one of the drawbacks to CAGR is that by smoothing the returns, CAGR cannot tell an investor how volatile or risky the stock fund was.
Track Performance
CAGR can also track the performance of various business measures of one or multiple companies alongside one another.
For example, over five years, Big-Sale Stores’ market share CAGR was 1.82%, but its customer satisfaction CAGR over the same period was -0.58%.
In this way, comparing the CAGRs of measures within a company reveals strengths and weaknesses.
Detect Weaknesses and Strengths
Comparing CAGRs of business activities across similar companies will help evaluate competitive weaknesses and strengths.
For example, Big-Sale’s customer satisfaction CAGR might not seem so low compared with SuperFast Cable’s customer satisfaction CAGR of -6.31% during the same period.
How Investors Use CAGR
Understanding the formula used to calculate CAGR is an introduction to many other ways investors evaluate past returns or estimate future profits.
The recipe can be manipulated algebraically into a recipe to find the present value or future value of money or calculate a hurdle rate of return.
For example, imagine that an investor knows that they need $50,000 for a child’s college education in 18 years, and they have $15,000 to invest today.
How much does the average rate of return need to be to reach that objective? The CAGR calculation can be used to find the answer to this question as follows:
\text{Required Return} =\, \left ( \frac{\$ 50,000}{\$ 15,000} \right )^{\frac{1}{18}}-1 = 6.90\%Required Return=($15,000$50,000)181−1=6.90%
This version of the CAGR formula is just a rearranged present value and future value equation. For example, if an investor knew that they needed $50,000 and felt it was reasonable to expect an 8% annual return on their investment, they could use this formula to determine how much they needed to invest to meet their goal.
Modifying the CAGR Formula
An investment is rarely made on the first day of the year and then sold on the last day. Imagine an investor.
who wants to evaluate the CAGR of a $10,000 investment that was entered on June 1st, 2013, and sold for $16,897.14 on September 9th, 2018.
Before the CAGR calculation can be performed, the investor will need to know the fractional remainder of the holding period. They held the position for 213 days in 2013, a full year in 2014, 2015, 2016, and 2017, and 251 days in 2018. This investment was held for 5.271 years, which calculated by the following:
- 2013 = 213 days
- 2014 = 365
- 2015 = 365
- 2016 = 365
- 2017 = 365
- 2018 = 251
The total number of days the investment was held was 1,924 days. To calculate the number of years, divide the total number of days by 365 (1,924/365), which equals 5.271 years.
The total number of years the investment was held can be placed in the denominator of the exponent inside CAGR’s formula as follows:
\text{Investment CAGR} =\, \left ( \frac{\$ 16,897.14}{\$ 10,000} \right )^{\frac{1}{5.271}}-1 = 10.46\%Investment CAGR=($10,000$16,897.14)5.2711−1=10.46%
Smooth Rate of Growth Limitation
The most critical limitation of CAGR is that it calculates a smoothed rate of growth over a period. It ignores volatility and implies that the change during that time was steady. Returns on investments are uneven over time, except bonds held to maturity, deposits, and similar assets.
CAGR does not account for when an investor adds funds to a portfolio or withdraws funds from the portfolio over the period being measured.
For example, if an investor had a portfolio for five years and injected funds into the portfolio during the five years,
the CAGR would be inflated. The CAGR would calculate the rate of return based on the beginning and ending balances over the five years and essentially count.
the deposited funds as part of the annual growth rate, which would be inaccurate.
Other CAGR Limitations
Besides the smoothed rate of growth, CAGR has other limitations. A second limitation when assessing investments is that, no matter how steady.
the development of a company or buy has been in the past, investors cannot assume the rate will remain the same in the future These fore.
the shorter the time frame used in the analysis, the less likely it will be for realized CAGR to meet expected CAGR when relying on historical results.
A third limitation of CAGR is a limitation of representation. Say that an investment fund was worth $100,000 in 2012, $71,000 in 2013, $44,000 in 2014, $81,000 in 2015 and $126,000 in 2016.
If the fund managers represented in 2017 that their CAGR was a whopping 42.01% over the past three years, they would be technically correct.
They would, however, be omitting some critical information And also the fund’s history, including the fact that the fund’s CAGR over the past five years was a modest 4.73%.
CAGR vs. IRR
The CAGR measures the return on an investment over a particular time. The internal rate of return (IRR) also measures investment performance but is more flexible than CAGR.
The most crucial distinction is that CAGR is straightforward enough that it can be calculated by hand.
In contrast, more complicated investments and projects, or those that have many different cash inflows and outflows, are best evaluated using IRR.
whatever financial calculator, Excel, or portfolio accounting system is ideal for backing into the IRR rate.
Example of How to Use CAGR
Let’s say an investor bought 100 shares of Amazon.com (AMZN) stock in December 2015 at $650 per share, for a total investment of $65,000. After three years, in December 2018, the stock has risen to $1,750 per share, and the investor’s investment is now worth $175,000.1 What is the compound annual growth rate?
Using the CAGR formula, we know that we need the:
- Ending Balance: $175,000
- Beginning Balance: $65,000
- Number of Years: 3
So to calculate the CAGR for this simple example we’d enter that data into the formula as follows:
\text{CAGR for Amazon} =\, \left ( \frac{\$ 175,000}{\$ 65,000} \right )^{\frac{1}{3}}-1 = 39.12\%CAGR for Amazon=($65,000$175,000)31−1=39.12%
It tells us that the compound annual growth rate for the investment in Amazon is 39.12%.
Frequently Asked Questions
What is a compound annual growth rate (CAGR)?
CAGR is a measurement used by investors to calculate the rate at which a quantity grew over time. The word “compound” denotes the fact that CAGR takes into account the effects of compounding or reinvestment over time.
For example, suppose you have a company whose revenue grew from $3 million to $30 million over ten years. In that scenario, however, CAGR would be approximately 25.89%.
What is considered a promising CAGR?
What counts as a promising CAGR will depend on the context. But generally speaking, investors will evaluate this by thinking about their opportunity cost and the riskiness of the investment.
For example, if a company grew by 25% in an industry whose average CAGR is closer to 30%, their results Night seem lackluster.
But if the industry-wide growth rates were lower, such as 10% or 15%, their CAGR might be very impressive.
What is the difference between a CAGR and a growth rate?
The main difference between a CAGR and a growth rate is that CAGR assumes the growth rate was repeated or “compounded” each year, whereas a standard growth rate does not.
Many investors prefer CAGR because it smoothes out the volatile nature of year-by-year growth rates.
For instance, even a highly profitable and successful company will likely have several years of poor performance during its life.
These bad years could significantly affect individual years’ growth rates, but they would have a relatively small impact on its CAGR.
Can CAGR be negative?
Yes. A negative CAGR would indicate losses over time rather than gains.
What is risk-adjusted?
To compare the performance and risk characteristics between various investment alternatives, investors can use a risk-adjusted [CAGR].
A simple method for calculating a risk-adjusted CAGR is multiplying the [CAGR] by minus the investment’s standard deviation.
If the standard deviation (i.e., its risk) is zero, the risk-adjusted [CAGR] is unaffected. The larger the standard deviation, the lower the risk-adjusted [CAGR] will be.
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