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.
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%.
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 can be used 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 widely used measure to evaluate and compare the performance of different investments.
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
GRn – Growth rate in period B
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.
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, it has been observed 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 CAGR doesn’t necessarily mean the highest CAGR; it means stable and consistent growth.
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