Compound Annual Growth Rate (CAGR)

Compound Annual Growth Rate (CAGR) is one of the most important tools. It provides a deep understanding of the growth of an investment over time. As an investor, you can use CAGR to understand the potential return on the investment. 

Keep reading to know, ‘What is CAGR?’, CAGR formula, ‘how to calculate CAGR?’, and more in detail. 

What is CAGR?

Compound Annual Growth Rate, or CAGR, helps to understand the annual growth rate of an investment over a specific period, considering the investment grows at a steady rate. It is important to show how much an investment would have increased if it had grown consistently growth through the period. 

Now that we have understood, ‘what is CAGR?’, let us understand, ‘How does CAGR work?’.

How does CAGR work?

Considering that the growth is compounded, the CAGR calculates the average annual growth rate of an investment over a certain duration.

For example, ABC Tech Ltd. recorded a market capitalisation compound growth rate of 28.4%, while its earnings grew at a CAGR of 24.1%.

This indicates that the company’s average market capitalisation increased by 28.4% annually over the past five years, while earnings showed a consistent year-on-year growth of 24.1%.

CAGR Formula

You can calculate the CAGR using the following formula:

CAGR = (FV / PV) 1 / n – 1

It determines the real-time CAGR for any organisation, where,

How to Calculate CAGR?   

Consider that you invested ₹5 lakh and that has grown to ₹9.1 lakh after 5 years. Using the formula, the CAGR of this mutual fund investment will be:

CAGR = (9.1 lakhs / 5.0 lakhs) ^ (1/5) - 1 = 12.67%

Applying the formula in detail can be time-consuming, so the easiest way is to simply use an advanced CAGR calculator on the website to get your result instantly.

How to use the CAGR calculator? 

Follow these simple steps to use the CAGR calculator online: 

• Step 1: Enter your initial investment amount.
• Step 2: Enter the expected value of the investment after a certain period.
• Step 3: Enter the number of years or months.

Within a few seconds, your CAGR will generate results.

What is CAGR in Stocks?

The rate of growth in average returns generated is showcased by the CAGR of total returns in the stock market. You must compare the expected rate of return with the CAGR before investing in any security, as it helps in understanding the profitability of the investment. 

You can use CAGR to analyse the long-term growth of the company without focusing on the short-term variations. It helps reject the unsystematic risk related to stock market instruments, due to variations in the economic conditions.

CAGR reflects the growth rate pro forma, i.e., excluding non-recurring fluctuations, as it smoothens out short-term variations. Using the CAGR, you get a clear idea about the performance of a company due to its internal structure.

Comparing the CAGR is important to understand whether a stock market tool is a value investment tool for long-term investment purposes. 

What are the uses of CAGR?

Below are a few significant uses of Compound Annual Growth Rate: 

• Risk Assessment

You can use CAGR to estimate risk related to an investment. For example, if the CAGR of an investment is constantly positive for a long time, it indicates a more stable growth pattern. 

• Long-term planning

You can use CAGR for assigning the potential growth of an investment over a period. It allows you to evaluate the future value of an investment and make a smart decision based on the expected average annual growth rate. 

• Performance comparison

You can use CAGR to compare the performance of different investments over a certain period. 

Advantages of CAGR

Here are some of the advantages of CAGR: 

• It helps in determining the profitability of an investment as it indicates the average performance of the same over a period.
• A short-term CAGR includes all the essential factors affecting the performance of such securities, including market parameters.
• It excludes all short-term variation for an extended time as security recovers quickly from such market shocks. It helps individuals in determining the actual potential of such companies.

Limitations of CAGR

Below are some of the limitations of CAGR:

• CAGR ignores market volatility as it assumes steady growth, which may not reflect real-world market changes. 
• It doesn’t show yearly changes and doesn’t highlight significant profits or losses in specific years. 
• It is not ideal for short-term analysis as it may not accurately show short-term performance. 
• CAGR must be used in combination with other financial indicators in order to make informed decisions.