CAGR: What You Should Know About CAGR
You so often get to hear statements like “the investment has given CAGR returns of 13% over 10 years”. Or you hear something like “Profits of Company X grew at a CAGR of 15% over the last 5 years”. What exactly is this CAGR and how is it useful in the world of finance and investments. More importantly, how do you make use of this CAGR concept for your own needs.
What Exactly is Meant by the Term CAGR?
CAGR or Compound Annual Growth Rate, is a measure of how your investments have compounded on an annualized basis. Let us dwell on the word compounding for a bit. Let us say you invested Rs.1,000 in a stock and it gave 10% returns. That will be stock price appreciation of Rs.100 in the first year. Now in the second year the price has again gone up by 10%.
Now, will the price by Rs.1,200 at the end of 2 years. The answer is No. Your Rs.1,000 has already grown to Rs.1,100 at the end of 1 year. Now a 10% growth on Rs.1,100 takes the investment value to Rs.1,210 at the end of 2 years. That is the concept of compounding which is the essence of CAGR or compounded annual growth rate.
How Should Investors Interpret CAGR Over A Period Of Time?
As we understood previously, CAGR shows us the average rate of return on your investments over a year. CAGR precisely measures the investment growth (or de-growth) over a period of time. It is a thumb rule that companies that create CAGR growth over 4-5 year periods are generally good stocks.
Remember, as we saw in the previous illustration, while calculating CAGR, profits are assumed to be reinvested at the end of each year of the time horizon. CAGR is representative and not accurate. That is because, when you say CAGR has grown 15% over 5 years, it does not mean that it consistently grew at that rate for all the five years. It may have varied between positive, flat and even negative growth during this period.
Where Can I Apply the Concept of CAGR?
This can be used for almost anything that grows over time. Like, you can use CAGR to measure growth over time in profits, sales, investment value, costs etc. Keeping this common application in mind, investors can find a convenient way to calculate CAGR. Today, you have online calculators to calculate the CAGR so it is much simpler. When the time period is too long like 5 years or 10 years, you cannot do it manually.
You either must use a scientific calculator or an excel spread sheet. The big advantage of the CAGR return is that it provides you with an annual average growth rate to see if you investment has been profitable. You can also get an approximate idea of what would be your returns post inflation, post-tax and post costs.
Can You Tell me How to Calculate CAGR Returns?
To calculate the compounded annual growth rate or CAGR, follow the following steps. These are very simple steps.
- Divide the investment value at the end of the period by the initial investment amount. Let us call the output as “X”.
- Calculate the nth root of “X”. That means if the period is 2 years then calculate square root of X and if it is 3 years then cube root of X and so on.
- From the output that you get from Step 2, deduct 1. The result is the CAGR in decimal terms. You can multiple by 100 to get CAGR in percentage terms.
You can convert the above explanation into a formula as under.
CAGR = {(FV / PV)1/n } – 1
Here, FV is the future value of the investment, PV is the present value of the investment, and n represents the number of years of investment.
Can You Explain Cagr to me With a Real Life Example?
Let us assume that your investment of Rs.10,000 grows to Rs.13,000 in 2 years. Normally, the period is longer, but for the sake of simplicity of calculations, we are just using 2 years here. Let us apply the CAGR calculation formula here.
CAGR = {(FV / PV)1/n } – 1
Now let us impute the numbers in the formula and what do we get?
CAGR = {(13,000 / 10,000)1/2 } – 1 = 14.02%
You can verify if the CAGR calculation is correct. At CAGR of 14.02%, the investment of Rs.10,000 grows to Rs.11,402 at the end of 1 year and to Rs.13,000 at the end of 2 years. That matches with our final value of the investment.
So, that is how the CAGR can be calculated. For longer tenures like 5 years or 10 years, it is simpler to use a scientific calculator or to use an excel spread sheet.
Can You Outline Some of The Advantages Of CAGR
Here are some of the merits of using CAGR to calculate long term average growth.
- It allows investors to assess the returns in a variety of scenarios. For example, you can simulate how much your initial investment will eventually grow to over a time period under different CAGR scenarios. This is useful in financial planning.
- It is simple to understand and easy to use. You only need to enter the initial value, the final deal, and desired investment period. You can make the calculation much easier by using online calculators or by using excel spread sheets or scientific calculators.
- Over a longer period of time, absolute returns can be misleading. In such cases, the CAGR can help you compare with other like instruments to know if you are doing better than the market. For example, if you purchased units of an equity fund earlier and that their value has increased, then you can easily use the CAGR to get a view of the average annualized gains made by you.
- CAGR is a return on capital measure and that is what matters when you have to compare with cost of funds. For example, if you cost of funds is 9%, then you need to look at an investment with CAGR returns of over 12% to make a spread.
- You can also use the compound annual growth rate calculator to compare stock performance in the peer group as well as with the index to see if the stock or fund manager is doing better or worse than the market benchmarks.