How to Calculate CAGR (Compound Annual Growth Rate)

Compound Annual Growth Rate (CAGR) is a widely used measure to determine the growth of an investment or project over a specific period. It shows the average annual growth rate of an investment, assuming that it grew at a steady rate over that period. In this article, we will discuss commonly asked questions related to the calculation of CAGR.

What is CAGR?

CAGR stands for Compound Annual Growth Rate. It is a financial metric that measures the rate of return of an investment or project over a specific period, assuming it grew at a constant rate.

How is CAGR different from simple average growth rate?

CAGR takes into account the compounding effect on the growth of an investment. It considers the year-on-year changes and calculates the average annual growth rate that would lead to the same final value. Simple average growth rate, on the other hand, calculates the arithmetic average of growth rates over a period.

How is CAGR useful?

CAGR provides a standardized way to measure the growth of investments. It helps investors compare investments with different time frames and identify those with consistent performance. CAGR also allows for easier forecasting and decision-making.

What is the formula to calculate CAGR?

The formula to calculate CAGR is: CAGR = (EV/BV)^(1/N) – 1, where EV represents the ending value of the investment, BV represents the beginning value, and N represents the number of years.

Can you explain the formula with an example?

Certainly! Let’s say you invest $10,000 in a stock and after 5 years, it has grown to $15,000. To calculate the CAGR, we use the formula mentioned earlier. Plugging the values into the formula, we get: CAGR = (15,000/10,000)^(1/5) – 1 = 8.7%. Therefore, the CAGR of this investment over 5 years is 8.7%.

What if the investment’s value decreases?

CAGR can also calculate negative growth rates if the investment value decreases. For example, if the initial investment of $10,000 decreases to $7,000 over a 3-year period, the formula would be: CAGR = (7,000/10,000)^(1/3) – 1 = -9.15%. This means that the investment had a compound annual growth rate of -9.15% over the 3 years.

Are there any limitations of using CAGR?

Yes, there are a few limitations. CAGR assumes that the growth rate remained constant over the entire period, which may not be true for all investments. It also does not account for any fluctuations that happened during the period. Additionally, CAGR can be biased by extreme values, outliers, or short periods.

Can CAGR be applied to any type of investment?

CAGR can be used for any investment or project that has a defined beginning and ending value. It can be applied to stocks, mutual funds, real estate, businesses, or any other asset class.

In conclusion, CAGR is a useful tool to measure the average annual growth rate of an investment or project over a specific period. The formula for calculating CAGR is relatively simple, and it can be applied to a wide range of investments. However, it is important to understand the limitations of CAGR and consider other factors while evaluating investments.