# Compound Annual Growth Rate (CAGR)

CAGR stands for Compound Annual Growth Rate. It's a method to see how much an investment or business has grown each year over a certain period.
Compound Annual Growth Rate (CAGR)
04-July-2024

Compound Annual Growth Rate or CAGR, is a metric used to measure the average annual growth of an investment over a specific period. It considers the effect of compounding, where earnings from previous periods are reinvested and contribute to future growth. This provides a more accurate picture of an investment's performance compared to a simple average of annual returns.

In this article, you will learn about CAGR meaning, how CAGR works, CAGR formula, and how to calculate CAGR in detail.

## What is CAGR?

CAGR (Compound Annual Growth Rate) represents the yearly average rate of revenue expansion over a specified period, under the assumption that growth occurs exponentially compounded between two particular years. It considers the impact of compounding, where earnings from previous periods are reinvested, boosting future growth. This makes CAGR one of the most accurate methods to determine returns on investments, portfolios, or anything whose value fluctuates over time. In simpler terms, CAGR provides a smoothed-out annual return on an investment over a specified period and represents the geometric mean of the rate of return.

For more clarity, let’s study an example. Say you put Rs. 2,000 into a specific mutual fund, which experienced a compound annual growth rate (CAGR) of 8% over seven years. This means that, on average, your investment would have grown by 8% each year. However, it is possible that the actual growth rate per annum might be different from this CAGR of 8%. Say, in the first year, it might grow by 6%, in the second year by 10%, and so forth.

## How does CAGR work?

CAGR, or Compound Annual Growth Rate, is a measure of the average annual growth rate of an investment over a certain period (assuming the growth is compounded). One key benefit of CAGR is its ability to smooth out year-to-year fluctuations in investment returns.

It is worth mentioning that investments usually do not grow at a steady rate; one year might see a significant increase, while another might experience a slight decline. To smooth out this fluctuation, CAGR averages these variations and provides a single growth rate. This makes it easier for investors to compare the performance of different investments.

To better understand the workings of CAGR, let’s study an example:

• Say you invested Rs. 1,00,000
• Your investment grew to Rs. 1,55,000 over eleven years
• Now, to calculate the CAGR, you must use this formula:
• CAGR = (Ending Value / Beginning Value)^(1 / Number of Years) – 1
• Upon calculation, the CAGR for this investment comes out to be 4.48%
• This means that, on average, the investment increased by 4.48% each year.

Moreover, CAGR considers the compounding effect. For those unaware, compounding in investments means that the returns earned in each period are added to the initial investment amount. This forms a new base on which all future returns are calculated. Due to compounding, you earn returns not only on your original investment but also on the accumulated returns from previous periods, accelerating your investment's overall growth.

As a result, the CAGR provides a more accurate measure of an investment's actual performance than a simple average of annual returns. While simple averages only give a basic arithmetic mean, CAGR accounts for the effect of compounding and shows how much an investment has grown on average per year by considering that the growth is reinvested.

Also read: What is XIRR in Mutual Funds

## Formula of Compound Annual Growth Rate (CAGR)

Calculating CAGR involves a simple formula:

CAGR = ((Ending Value/Beginning Value)^(1/Number of Years) - 1)*100

Here is what each part means:

• Ending Value: This represents the investment's worth at the end of the period you are analysing.
• Beginning Value: This is the investment's worth at the beginning of the period.
• Number of Years: This refers to the total duration of the investment period.

By plugging these values into the formula, you can calculate the average annual growth rate that considers compounding.

## How to calculate CAGR?

To calculate CAGR, you can follow these simple steps:

• Identify the starting value, which is the initial amount you invested or the initial value you are measuring.
• Next, determine the ending value, which is the value at the end of the specified period.
• Now, calculate the total number of years over which the growth occurred.
• Use the CAGR Formula:
• CAGR = (Ending Value / Beginning Value)^(1 / Number of Years) – 1
• Multiply the result obtained by 100. This will help you get the CAGR as a percentage.

For a better understanding, let’s see a hypothetical example:

• Starting value: Rs. 10,000
• Ending value: Rs. 15,000
• Number of Years: 5

Now, let us plug these values into the formula:

• CAGR = (15,000 / 10,000)^(1 / 5) – 1
• CAGR = 0.08447 or 8.45%

Here, we can observe that the CAGR is 8.45%. This means that, on average, the investment grew by 8.45% per year over the 5 years.

## CAGR Example

Say, Ram, a mutual fund investor, invested Rs. 5,000 in a mutual fund scheme in 2021. In the next three years, the value of his investment grew to Rs. 6,500. Now, let’s calculate the CAGR of the investment made by Ram:

• Starting value (2021): Rs. 5,000
• Ending value (2024): Rs. 6,500
• Number of years: 3 years

Putting the above values in the CAGR formula:

CAGR = (6,500/5,500)^1/3 - 1

CAGR = 9.10%

Here, we can observe that the CAGR of the mutual fund scheme is 9.1% over a 3-year period. This means that the investments of Ram grew on average at a single rate of 9.10% in 3 years.

## How to calculate CAGR in Excel?

It must be noted Excel doesn't have a specific built-in function to calculate "CAGR". However, you can still calculate it using several other functions, such as:

• RRI function:
• This function directly computes CAGR by specifying:
• The number of periods
• Starting value
• Ending value
• IRR function:
• It can calculate CAGR when you provide a range of cash flows, including the initial investment.
• RATE function:
• Usually, this function is used to calculate the interest rate for a series of equal cash flows—for example, loans or investments with regular payments.
• When adapted for CAGR, this function can also be used to determine the annual growth rate of an investment.

## What is a good CAGR?

For large-cap companies, a CAGR in sales ranging from 5% to 12% is considered favorable. Conversely, smaller companies typically aim for a higher CAGR, typically falling between 15% to 30%. Start-up ventures often exhibit remarkable growth rates, with CAGRs ranging from 100% to 500% in their initial stages. Although such steep growth rates are not uncommon, maintaining consistency in CAGR is crucial.

## Uses of Compound Annual Growth Rate (CAGR)

Compound Annual Growth Rate (CAGR) serves multiple purposes in financial analysis.

• Performance Benchmarking: CAGR offers a standardised metric for comparing the performance of diverse investments over a specific timeframe. This method ensures an equitable evaluation, allowing investors to gauge investments uniformly based on average annual growth rates rather than absolute figures.
• Strategic Long-Term Planning: CAGR proves instrumental in long-term investment planning by estimating the potential growth trajectory of an investment over time. Investors can project the future value of their portfolios, enabling informed decisions grounded in expected average annual growth rates.
• Risk Analysis: CAGR functions as a valuable tool for assessing investment risk. Consistently positive CAGR over an extended period suggests a more stable and reliable growth pattern, particularly appealing to risk-averse investors.
• Historical Performance Assessment: Through CAGR, investors can scrutinize the historical performance of their portfolios. Comparative analysis against benchmark indices or industry standards facilitates the evaluation of investment strategy effectiveness and identification of areas for improvement.

Also read: What is Mutual Fund Switching

## Advantages of Compound Annual Growth Rate

Listed below are some advantages of Compound Annual Growth Rate:

• Simplicity: CAGR simplifies the representation of complex, multi-year growth rates into a single percentage, making it easier for investors to compare investments.
• Long-Term Perspective: CAGR is particularly useful for assessing long-term investments, as it smooths out short-term fluctuations and provides a clearer view of performance over time.
• Effective for Variable Returns: It is valuable when an investment has experienced variable or erratic returns over time. CAGR gives a single, consistent growth rate that encapsulates the investment's overall performance.
• Applicability: The CAGR concept is versatile and can be applied to various asset classes, including mutual funds, stocks, real estate and businesses, making it a valuable tool for investors across different domains.

## Limitations of CAGR

While Compound Annual Growth Rate (CAGR) is a valuable metric for understanding the average annual growth of an investment over a period, it also has some limitations that should be considered:

Assumes Constant Growth: CAGR assumes that the investment's growth or decline is constant year after year, which may not reflect the actual market dynamics. In reality, investment returns can be volatile and fluctuate significantly over time.

No Insight into Intermediate Values: CAGR provides the average growth rate but does not offer insights into the investment's performance during individual years. It smooths out the data, potentially hiding periods of exceptional gains or losses.

Dependent on Time Frame: The CAGR value can change significantly depending on the selected time frame. For example, the CAGR for a five-year period may differ from that of a ten-year period, leading to different interpretations.

Not Suitable for Short-Term Investments: CAGR is best suited for evaluating long-term investments. For short-term investments with high volatility, the metric may not accurately represent the investment's performance.

Ignores Investment Timing and Cash Flows: CAGR does not consider the timing of investments or cash flows. It assumes that the investment was made at the beginning and held until the end of the period, which may not be the case for all investors.

## Factors to Consider When Using CAGR

When using CAGR to analyse investments, there are several important factors to consider:

• Time period: The length of time used to calculate CAGR is critical. A longer period generally gives a more accurate picture of returns, while a shorter period might be misleading. Hence, make sure you are using consistent time when comparing different investments.
• Market fluctuations: Numerous studies have shown that market fluctuations substantially affect CAGR. There is a chance that an investment that shows high returns over a short period may not sustain those returns over the long term. Hence, it is always important to consider market trends and volatility when evaluating investments.
• Risk: CAGR does not account for the risk involved with an investment. A higher CAGR might indicate better returns, but it may not be the best choice if the investment is high-risk. Thus, you must always assess the risk level alongside the CAGR.
• Currency fluctuations: For investments made in foreign currencies, changes in exchange rates can impact the CAGR. Therefore, it is necessary to factor in these currency fluctuations when analysing returns.
• Taxes and fees: Taxes and fees significantly reduce the actual returns on an investment. Hence, while calculating CAGR, consider how these costs might affect the overall growth rate.

## CAGR – Key points to remember

Here are a few points to remember about CAGR:

• CAGR does not solely measure sales growth within a specific time frame; growth concentration might vary, focusing on either the initial or final year of a project.
• Investments with identical rates of return could yield different profitability levels due to variations in the timing of growth; one investment might experience faster growth in the initial year, while another may see growth primarily in the final year.
• CAGR is commonly used for investment durations spanning three to seven years; however, for periods exceeding ten years, it may obscure intermittent patterns.
• It's important to differentiate between CAGR (Compound Annual Growth Rate) and the annual growth rate as they serve distinct purposes

## Conclusion

Understanding Compound Annual Growth Rate (CAGR) empowers you to make informed investment decisions. CAGR goes beyond simple averages by factoring in compounding, providing a clearer picture of long-term investment growth. While limitations exist, CAGR remains a valuable tool for tasks like benchmarking performance, strategic planning, risk analysis, and historical assessment. Remember, a good CAGR is context-dependent, but surpassing comparable investments is generally positive. Utilise CAGR alongside other metrics to gain a comprehensive understanding of your investments' health and chart a course for financial success.

## Essential tools for mutual fund investors

Why is CAGR important?

An investor can use CAGR to determine how much to invest right away to meet a particular investment objective over time. The compounding factor is ignored in these calculations, even though annual returns are frequently used to assess mutual funds and stocks. These metrics frequently overestimate returns as a result, which can result in making bad investment choices. A standard rate of compounding can be used to produce results from CAGR that are more precise. It can also be used to compare stocks or mutual funds, analyse the performance of an investment, and even monitor business performance.

What is CAGR Formula?

Calculating CAGR is a straightforward process that requires three inputs: the initial investment amount, the final maturity amount, and the investment tenure. The formula is as follows:

CAGR = ((Ending Value / Beginning Value)^(1 / Number of Years) - 1)*100

What is CAGR with examples?

CAGR helps determine the smoothed annual growth rate of investments. For example, suppose you invest Rs. 1,000 in a financial instrument and it grows to Rs. 1,800 after five years. The CAGR would be ((1800/1000)^(1/5) -1)*100 = 12.47%.

What does a three-year CAGR mean?

A three-year CAGR represents the average annual growth rate of an investment over a three-year period. It's calculated by considering the starting and ending values over those three years and finding the rate of growth necessary to achieve that result. This CAGR provides insight into the investment's performance during that specific three-year window.

How do you convert CAGR to annual growth?

CAGR is already an annual growth rate, representing the compounded growth of an investment annually. There is no need to convert CAGR to another annual growth rate, as it's a consistent annual measure.

Can you use CAGR for months?

CAGR is primarily used for longer time frames, typically years, as it smoothes out annual growth rates. It's not commonly used for monthly performance analysis because monthly variations can be more volatile, and CAGR is better suited for assessing long-term trends.

How to calculate the CAGR of a Company?

To calculate a company's CAGR, determine the starting and ending values of an investment (e.g., stock price, revenue), and the time period you want to analyse.

Is a CAGR of 30% good?

A CAGR of 30% is considered exceptional and signifies robust growth over time. It indicates that an investment's value has consistently increased by an average of 30% annually, showcasing its potential for high returns and strong performance.

How is CAGR calculated for SIP?

CAGR for Systematic Investment Plans (SIPs) is calculated by taking the nth root of the ending value of the investment divided by the initial investment, where n is the number of years. This formula helps gauge the average annual growth rate of the investment.

What is the rule of 72 for CAGR?

The rule of 72 estimates the time it takes for an investment to double in value based on its Compound Annual Growth Rate (CAGR). By dividing 72 by the CAGR, you can approximate the number of years it will take for the investment to double in value.

What is the rule of 70 in CAGR?

Similar to the rule of 72, the rule of 70 estimates the doubling time for an investment based on its CAGR. By dividing 70 by the CAGR, you can approximate the number of years it will take for the investment to double in value.

What is the difference between CAGR and growth rate?

The Compound Annual Growth Rate (CAGR) provides a smoothed-out, annualized measure of growth over a specified period, considering compounding effects. In contrast, the growth rate typically refers to the rate of change in value over a single period, without necessarily accounting for compounding.

What does 10% CAGR mean?

A 10% CAGR signifies that an investment, on average, grew by 10% annually over a specific period. This considers compounding, meaning your returns are earned on both the initial investment and the accumulated earnings from previous years.

What does 20% CAGR mean?

Similar to 10% CAGR, a 20% CAGR indicates an average annual growth of 20% over a certain timeframe. This represents a potentially strong performing investment, but remember, past performance doesn't guarantee future results.

Is a CAGR of 7% good?

Whether 7% CAGR is good depends on your investment goals and timeframe. It is generally considered a decent average return, but compared to historical stock market performance (around 10%), it might be lower. Consider your risk tolerance and compare it to other options.

What does 5% CAGR mean?

A 5% CAGR suggests an average annual growth of 5% over a specific period. This growth might outpace inflation, but it may not be ideal for long-term wealth building goals. Analyse it alongside your investment objectives.

Is 100% CAGR good?

While a 100% CAGR sounds incredibly attractive, it is essential to be cautious. Such high growth rates are uncommon and can be risky. It's advisable to research thoroughly before investing in anything promising a 100% CAGR.

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