Investment returns are evaluated differently by numerous investors — some consider capital gains, and yet others consider annual returns. This is where the role of CAGR or Compound Annual Growth Rate becomes crucial. What is CAGR exactly, and how do you fathom it? Let us deconstruct what it implies.
What is CAGR?
It stands for Compound Annual Growth Rate.
It is the rate at which investment grows on average annually, over a certain period, and with the assumption that profits were reinvested at the end of each year.
In simple terms, it is the rate telling you how much your investment would have grown each year had it compounded steadily at that rate on an annual basis.
Why is CAGR Important?
- It eliminates the effects of volatility in returns.
- It gives one growth rate by which different investments can be compared.
- It helps in setting a benchmark for realistic growth expectations.
Suppose your investment grew at different rates every year — CAGR simplifies that into one rate, uniform for every year.
CAGR Formula
The formula for CAGR is:
Where:
- Beginning Value = Value of the investment at the start
- Ending Value = Value of the investment at the end
- n = Number of years
How to Calculate CAGR (Example)
Let’s say you invested ₹1,00,000 in a mutual fund. After 5 years, it grew to ₹1,80,000.
- Your investment grew at an average annual rate of about 12.57% over the 5 years.
Things to Remember About CAGR
- CAGR assumes smooth growth — but real investments can be volatile.
- It doesn’t reflect year-to-year fluctuations or market risks.
- Useful for comparing long-term investments like stocks, mutual funds, or business revenues.
Interpreting CAGR Results
What does a high or low CAGR tell you?
- High CAGR: Success! Your investment or business is growing fast and steady.
- Low CAGR: The growth is slow or nonexistent. Maybe time for a fresh perspective.
Evenly comparing the CAGR across various assets or time can help determine which has been the best investment. But, always remember that the CAGR assumes growth to be smooth and continuous, which in reality, it generally is not. There can be instances of sudden dips in the market, and these could camouflage the picture.
Some professionals suggest that the CAGR is misleading if used alone. It does not measure fluctuations or risk. To get a full picture, use other metrics together with CAGR, for example, volatility or maximum drawdown.
Practical tips for effective use of CAGR
To get the most out of CAGR, follow all the below tips:
- Always use CAGR in conjunction with other ratios like ROI, working margins, or debt ratios.
- Use the trends of CAGR in projecting future growth while remaining cautious about excessively optimistic forecasts.
- If sharing results, it is paramount to explain how CAGR was calculated to all stakeholders involved.
- Always update the calculation of CAGR so that it will contain the most recent data, and thus, your analysis should remain relevant.
As you become more familiar with CAGR, you’ll spot opportunities and risks faster. It’s a simple number, but its insights run deep.
Final Thoughts
CAGR is a simple yet powerful tool that helps you understand how your investments have performed over time — as if they had grown at a steady rate. Whether you’re comparing mutual funds, stocks, or even your business’s sales growth, knowing how to calculate and interpret CAGR can make you a smarter investor!
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