What is Compound Annual Growth Rate (CAGR)?
CAGR stands for compounded annual growth rate. It measures an investment’s annual growth rate while taking into consideration the reinvested profits. In other words, CAGR is the rate at which an investment grows each year for the entire tenure of the investment. It helps in comparing similar investments and aids in decision making.
How to Calculate CAGR?
The formula for CAGR:
CAGR = [(Ending value/Beginning Value)^(1/N)]-1
Where, N is the number of years
We will understand the below with the help of an example:
Suppose the beginning value of the investment is Rs 1,00,000 and the ending value of the investment is Rs. 1,50,000 over a period of 2 years. CAGR would be calculated as below:
CAGR = [(1,50,000/1,00,000)^(1/2)] -1
How to Intepret CAGR?
Compound Annual Growth Rate (CAGR) is the rate of return at which the investment grows every year from beginning balance to ending balance, assuming the profits are reinvested each year.
CAGR tells the rate at which an investment has grown each year to reach the ending value. It is an average return of an investment over a period of time. CAGR smooths out the returns from an investment over the investment tenure. One can use compound annual growth rate to compare the returns from different investments.
CAGR is not the true return but a representational number. An investment generally cannot grow at the same return each year. However, for comparison with alternative investments, CAGR is used.
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What is Considered a Good CAGR Percentage?
Compounded annual growth rate (CAGR) shows how much an investment grows over a specific period. Simply put, it is the average return an investor earns on the investments after a given interval. CAGR takes into account the duration of investment and computes the returns. It is an approximate rate at which an investment would grow if there isn’t any volatility.
There is no definite percentage for a good CAGR when it comes to equity investments. It is a combination of many factors. However, the CAGR should ideally be more than the saving account interest rate for most investments – equity or fixed income.
Historically, in the long term, large and strong companies have given a return between 8% to 12% to their investors. Therefore, investors looking for stable returns and with a long term investment horizon can invest in large-cap companies. The potential compound annual growth rate can be around 8% to 12% in the long term.
On the other hand, small and mid-cap companies have a greater potential to earn higher returns. However, these investments are highly volatile. Hence, investors who understand and are willing to undertake the risk can invest in such companies. Historically, returns from these investments have been over 15%.
Is CAGR a Good Measure?
CAGR is considered as a good and valuable tool for measuring the performance of an investment. CAGR is considered as one of the most accurate ways of calculating historical returns. It takes the beginning and ending value of an investment and calculates the return based on the time period of investment.
CAGR is useful to compare the performance of different investment options. Since the returns are smoothened out, one can easily compare the returns from two different investments. Using CAGR, one can project or estimate future returns from the investment. CAGR forms the basis of all future projections.
However, CAGR has some disadvantages too. It ignores all the cash inflows and outflows that happen during the investment. It takes into consideration the beginning and ending value to compute return. CAGR doesn’t consider investment risk. Moreover, it assumes a constant growth rate during investment tenure.
Despite its disadvantages, CAGR is a popular measure to evaluate and compare the performance of different investments.
How Do I Calculate the Average Growth Rate?
The Average Annual Growth Rate (AAGR) is the average increase in the value of an investment over a year. It is essentially the arithmetic mean of a series of growth rates. One can calculate the AAGR for any investment. However, it doesn’t account for the investment’s overall risk, i.e. price volatility.
Formula for AAGR
GRA – Growth rate in period A, GRB – Growth rate in period B, and GRn – Growth rate in the period N
N – Number of payments
The AAGR helps in determining the long term trends. The ratio tells what the annual return has been on an average. Hence, its applicability is across all kinds of financial measures.
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What is the Growth Rate?
The growth rate is a measure of change in the value of an investment or goods from one time period to another. It is expressed in terms of percentage and usually is in the form of annual rates for easy comparison.
Formula for growth rate between two time periods:
Growth rate = ((Value1– Value0)/ Value0)*100
Value0 – Value in year 0
Value1 – Value in year 1
Let’s understand this better with an example. Let’s say you invested INR 5,000 today, and the value of this investment after a year is INR 6,500. The growth of your investment is 30% in one year.
What is a Good Growth Rate for a Company?
Compound annual growth rate is an important factor for an investor, CEO or a businessman. The CAGR will guide an individual to know the demand and valuation of a company’s services and products, also, as a whole company’s performance.
Many factors play a role in the growth rate of a company. For example, business is at what stage of the life cycle. Is it in the start-up stage and growth stage, or is it mature, in decline or undergoing renewal? Ideally, the growth rate should be sustainable despite being fast or slow growth.
Size of the company and also the industry sector plays a role in the growth rate of a company. For large-cap companies, a CAGR in sales of 5-12% is good. Similarly, for small companies, a CAGR between 15% to 30% is good. On the other hand, start-up companies have a CAGR ranging between 100% to 500%. Also, such high growth rates in the early stages are not completely abnormal. Furthermore, a company needs to maintain consistency in its CAGR. Therefore, a good compound annual growth rate doesn’t necessarily mean the highest CAGR; it means stable and consistent growth.
You may also like to read about the Absolute Return vs CAGR
Frequently Asked Questions
CAGR (Compound Annual Growth Rate) means the rate of return of the investment that grows every year over a specified period of time. In other words, it is a measure of how much an investor has earned on investments every year during a given time frame. Investors can use CAGR to compare returns from different investments.
A growth rate is a measure of the percentage increase of a given metric over a period of time. The basic way to calculate the growth rate is by subtracting the current value from its previous value. The difference is divided by the previous value and multiplied by 100. This gives a percentage representation of the growth rate. The growth rate may vary from industry growth rate to company growth rate to economic growth rate.
CAGR is the actual annual growth rate of an investment over a specific period, whereas the growth rate is a percentage increase over a period of time. Usually, growth rates are used to study population size, corporate management or economic activity. However, CAGR is a variation of growth rate, which is often used to assess investment performance.
The 5-year CAGR represents the five-year financial performance of a mutual fund or company. It is a suitable metric to compare the performance of different funds and companies at a time. For example, if you want to invest in a mutual fund, the 5-year CAGR will help determine how the fund performed in the last five years.
Yes, you can calculate the CAGR for months. However, it is called Compound Monthly Growth Rate. The formula remains the same as CAGR, and you must simply replace the number of years with the number of months.
CAGR helps you estimate returns when you are making lumpsum investments. On the other hand, XIRR is a more suitable metric for estimating returns where the investments are at different periods. Thus, the compound annual growth rate is useful for lumpsum investments, while XIRR is for SIP investments.