Definition of CAGR
The rate at which annual growth of investments over a specific period assuming the profits were reinvested at the end of each year of the investment’s lifespan is known as Compound Annual Growth Rate (CAGR). In other words, CAGR is a measure of how much have earned on your investments every year during a given interval. This is one of the most accurate methods of calculating the rise or fall of your investment returns over time.
CAGR Formula
CAGR = (Ending balance / beginning balance)1/n - 1
Here,
Ending balance is the value of the investment at the end of the investment period.
Beginning balance is the value of the investment at the beginning of the investment period.
‘n’ is the number of years has invested.
Use of CAGR
Generally, people tend to look at returns in absolute terms. Imagine you have invested ₹1,00,000 in a particular mutual fund for a period of 3 years. At the end of the 3rd year, the value of your investment grew to ₹1,85,000. In absolute terms, your fund has generated a return of 85% over the 3 years. You could say that your money has nearly doubled during this period. However, this can be a bit misleading. It does not tell you how much your investment has actually grown over each year. This is where CAGR becomes very useful. Here, we can calculate the CAGR to understand its benefits.
CAGR
= (185000/100000)1/3 - 1
= 23%
In other words, your investment in the fund has given you an average return of 23% every year over the last 3 years. Essentially, CAGR tells the compounded returns you earn on an annual basis irrespective of the individual yearly performances of the fund. This is because your investments do not grow at the same rate every year. Some years, you may have high returns while during other years, your returns may be lower. In fact, it is possible to earn negative returns too. CAGR provides you with the information of the average returns earned by a fund every year in a certain time period. This is not a true rate of return. Rather, it is a representational figure of how much your investment growth provided they grew at the same rate every year. By knowing CAGR, you can understand how your fund is performing and thereby you can take necessary investment actions. Calculation of CAGR can help to mutual fund investors as following :-
(a) Better investment decisions
The CAGR helps you to analyze your investment decisions every year. For instance, if you have purchased an equity mutual fund 5 years ago, the CAGR gives you the average rate of returns you have earned every year over the past 5 years. This can help you to understand whether the fund's returns are as per your expectations or not. If the fund is not performing well, you may want to reconsider your investment in the future.
(b) Compare returns between different funds and benchmarks
You can also use the CAGR to compare the returns you earn on a particular fund against similar funds. This can help you understand how well the mutual fund is performing compared to its peers. You can also compare against the benchmark indices for greater clarity. In other words, Investors can compare the CAGR of two alternatives to evaluate how well one stock performed against other stocks in a peer group or against a market index.
Calculation of CAGR :-
Example 1 :-
Imagine you invested $10,000 in a portfolio with the returns outlined below:
From Jan 1, 2014, to Jan 1, 2015, your portfolio grew to $13,000 (or 30% in year 1).
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 on an annual basis, the year-to-year growth rates of the investment portfolio were quite different 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 so different from 2015. The CAGR over that period was 23.86% and can be calculated as follows:
CAGR = ($19,000 / $10,000)1/3 -1
=23.86%
The compound annual growth rate of 23.86% over the three-year investment period can help an investor compare alternatives for their capital or make forecasts of future values. For example, imagine an investor is comparing the performance of two investments that are uncorrelated. In any given year during the period, one investment may be rising while the other falls. This could be the case when comparing high-yield bonds to stocks, or a real estate investment to emerging markets. Using CAGR would smooth the annual return over the period so the two alternatives would be easier to compare.
Example 2 :-
An investment is rarely made on the first day of the year and then sold on the last day of the year. 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 days
2015 = 365 days
2016 = 365 days
2017 = 365 days
2018 = 251 days
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 i.e. (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:
Investment CAGR = ($16,897.14 / $10,000)1/5.271
−1
=10.46%
Limitations of CAGR
CAGR works suitably for lumpsum investments. In case of Systematic Investment Plans (SIPs), it does not take the periodic investments into account as it only considers the initial and final values for the calculation. CAGR does not reflect investment risk.
CAGR vs. IRR
The CAGR measures the return on an investment over a certain period of time. The internal rate of return (IRR) also measures investment performance but is more flexible than CAGR. The most important 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. To back into the IRR rate, a financial calculator, Excel, or portfolio accounting system is ideal.
Conclusion
CAGR is a very useful method to calculate the growth rate of an investment. It can be used to evaluate the past returns or estimate the future returns of your investments. Overall, the CAGR is a very useful tool, and it can help us to analyze our investments.
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