What is CAGR and How to Use It
4 minutes for reading
This article is devoted to a financial ratio called CAGR: what it is, what it is used for, and what drawbacks it has. And of course, it will show you how to calculate the indicator and will give examples of its use.
What is CAGR
CAGR stands for Compound Annual Growth Rate and is used for assessing how much an investment will grow over a certain timeframe. In other words, this indicator demonstrates how much profit an investor will make annually on their investment over a certain period. This is a popular method for estimating return on investment.
Unlike with banking deposits, in the stock market your capital grows unevenly; at certain moments, it may drop. The mathematical CAGR calculation formula demonstrates a smoothed out profit, helping you see average return on investment over several years. This multiplier suits long-term investments.
As for the question what CAGR is, it can be answered like this: it is an instrument that helps investors analyse investment yield. For example, 5 years ago you invested in a fund, so now with CAGR you can calculate the profit you were making annually over those 5 years. Based on this data, you can analyse whether the yield from investment meets your expectations.
How to calculate CAGR
Compound Annual Growth Rate formula looks as follows:
CAGR = ([EV/BV]^1/n−1) * 100%
Where:
- EV is the final cost of investment
- BV is the initial cost of investment
- n is the investment period.
Example of using CAGR
The size of investment is $1,000. It was put in an investment fund for three years. By the end of the last year, the cost of the investment grew to $1,850. Speaking absolutely, the fund earned 85% over this timeframe. Hence, the investment nearly doubled, but this is quite general information, because the investor needs to know what factual return on investment they got.
And here, Compound Annual Growth Rate will be helpful, giving the investor information about their annual return on investment.
CAGR = ([(1850/1000)^(1/3)]−1) * 100% = 23%
Calculation shows that the investment annually brought the investor 23% over three years.
Use of CAGR
- Calculating average yield of investment funds
- Comparing efficacy of the work of financial managers
- Comparing profitability of different financial assets on history
- Forecasting future profits based on previous profitability results
- Analysing economic performance of companies: sales, spending, profitability, etc.
Drawbacks of CAGR
- Compound Annual Growth Rate implies constant growth over the whole investment period. This smoothing mechanism demonstrates averaged results that might differ from the real situation in highly volatile investments.
- CAGR is based on the results of the previous timeframe and cannot guarantee that the return on investment will remain the same when the market conditions change.
- CAGR is timeframe-sensitive, so investment funds can manipulate Compound Annual Growth Rate, choosing the TF with the most impressive profitability.
CAGR vs IRR
Apart from CAGR, return on investment over a certain period can be assessed with the Internal Rate of Return (IRR). This multiplier demonstrates internal rate of return that shows the efficacy of investments. IRR is a more flexible index that deals with situations with intermediate money flows which require more detailed calculations.
The main difference between CAGR and IRR is that Compound Annual Growth Rate is easy to calculate, requires few initial data, and has a simple formula that quickly demonstrates approximate yield on investment. More complicated investments and projects that have a lot of money in-flows and out-flows are better assessed with IRR.
CAGR is good for one-time investments in instruments with constant profitability. When the yield fluctuates, and money is sometimes added up, IRR is better.
Bottom line
Compound Annual Growth Rate is a ratio by which the investor estimates annual growth of return on investments. It can be used for estimating past investments or forecast future profits. CAGR is a good instrument for fast comparison of various investment options.
To calculate CAGR, a simple formula will do – take a look at the example above. Analysts recommend that for a more detailed analysis CAGR should be used alongside other financial indicators.
