CAGR (Compound Annual Growth Rate)- Meaning & Formula (2024)

Compound Annual Growth Rate or CAGR is the annual growth of your investments over a specific period of time. In other words, it is a measure of how much you have earned on your investments every year during a given interval. This is one of the most accurate methods of calculating the rise or fall of your investment returns over time.

In this article, we will delve into the concept of CAGR, its significance, and how it can help investors make informed decisions.

1. What Is CAGR?

CAGR stands for Compound Annual Growth Rate. It is a way to measure how an investment or business has grown over a specific period of time. It takes into account the effect of compounding, which means that the growth builds upon itself.

For example, if you invested Rs 1,000 in a particular mutual fund, it grew at a CAGR of 10% over five years. It means that, on average, your investment would have increased by 10% each year. However, the actual growth in each year may vary. In the first year, it could be 8%, in the second year, it could be 12%, and so on. By using CAGR, you can get a consistent growth rate that can be utilized for comparison, as it smooths out any fluctuations.

CAGR is useful because it helps you evaluate investment opportunities or assess the historical performance of investments. It allows you to compare different investments on a consistent basis and make informed decisions. It’s a way to measure and understand the steady growth of your money over time.

Remember that CAGR takes into account the effect of compounding, allowing you to evaluate the average annual growth rate and compare investments more accurately over time.

2. CAGR Formula

The Compound Annual Growth Rate (CAGR) formula is as follows:

CAGR =(Ending balance/beginning balance)^1/n– 1

Here,

• The ending balanceis the value of the investment at the end of the investment period
• Beginning balanceis the value of the investment at the beginning of the investment period
• Nis the number of years you have invested

3. How CAGR Works?

CAGR, or Compound Annual Growth Rate, works by calculating the average annual growth rate of an investment over a specific period, assuming that the growth is compounded.

Let’s understand how CAGR works with an illustration:

CAGR calculates an investment’s average annual growth rate over a specific period, considering compounding. Let’s consider an investment with a starting value of Rs 100,000, and it grew to Rs 155,000 at the end of eleven years.

To calculate CAGR, we use the formula: CAGR = (Ending Value / Beginning Value)^(1 / Number of Years) – 1.

Using the formula, we calculated the CAGR for this investment = 4.48%

This means that, on average, the investment grew by approximately 4.48% per year over the eleven-year period.

The below graph shows how CAGR smooths out these fluctuations and gives you a single rate of growth that you can use for comparison purposes. On the other hand, the annualized returns show the investment’s performance every year.

CAGR considers the compounding effect, where the growth each year contributes to the base value for subsequent years. It gives you a single rate of growth that reflects the investment’s overall performance, making it easier to compare different investments.

By calculating CAGR, you can evaluate investments objectively and gain insights into their long-term performance. It helps you understand how an investment has grown consistently over time and make informed decisions based on the average yearly growth rate.

4. How to Calculate Compound Annual Growth Rate (CAGR)

To calculate the Compound Annual Growth Rate (CAGR), follow these steps:

• Determine the starting value (the initial investment or any other value you are measuring) and the ending value (the value at the end of the specified period).
• Calculate the total number of years or periods over which the growth occurred.
• Use the formula: CAGR = (Ending Value / Starting Value)^(1 / Number of Years) – 1.
• Multiply the result by 100 to express the CAGR as a percentage.

Here’s an example to illustrate the calculation:

Let’s say you invested Rs 10,000 in any mutual fund and after 5 years, it grew to Rs 15,000.

Starting Value: Rs 10,000

Ending Value: Rs 15,000

Number of Years: 5

CAGR = (Rs 15,000 / Rs 10,000)^(1 / 5) – 1

CAGR = 0.08447 or 8.45%

The CAGR in this case is approximately 8.45%, indicating that the investment grew by an average of 8.45% annually over the 5-year period.

5. Why is CAGR useful to you

Generally, people tend to look at returns in absolute terms. Imagine you have invested ₹1000 in a particular mutual fund for a period of three years. At the end of the third year, the value of your investment grew to ₹1,850. In absolute terms, your fund has generated a return of 85% over the three years. You could say that your money has nearly doubled during this period. However, this can be a bit misleading. It does not tell you how much your investment has grown each year. This is where CAGR becomes very useful.

Here, let’s calculate the CAGR to understand its benefits.

CAGR = [(1850/1000)^(1/3)] – 1

OR

CAGR = 23%

In other words, your investment in the fund has given you an average return of 23% every year over the last three years.

Essentially, CAGR lets you know the compounded returns you earn on an annual basis irrespective of the individual yearly performances of the fund.

This is because your investments do not grow at the same rate every year. In some years, you may have high returns while during other years, your returns may be lower. In fact, it is possible to earn negative returns too.

CAGR provides you with information on the average returns earned by a fund every year in a certain time period. This is not a true rate of return. Rather, it is a representational figure of how much your investment growth provided they grew at the same rate every year.

6. Use of CAGR

There are multiple uses for Compound Annual Growth Rate (CAGR).

• Performance comparison: CAGR provides a standardized measure to compare the performance of different investments over a specific period. It allows investors to evaluate investments equally, considering the average annual growth rate rather than absolute numbers.

• Long-term planning: CAGR helps in long-term investment planning by estimating the potential growth of an investment over time. It allows investors to project the future value of their investments and make informed decisions based on the expected average annual growth rate.

• Risk assessment: CAGR can help assess the risk associated with an investment. If the CAGR of an investment is consistently positive over a long period, it indicates a more stable and reliable growth pattern, which may be attractive to risk-averse investors.

• Performance evaluation: CAGR enables investors to evaluate the historical performance of their investments. By comparing the CAGR of their investments against benchmark indices or industry standards, investors can gauge their investment strategies’ effectiveness and identify improvement areas.

7. CAGR Calculator

TheCAGR calculatoris a simple online tool that gives you the annual rate at which your investment has grown. All you need to do is provide certain input data and the calculator does the rest.

You need to input:

• The beginning value of the investment
• The ending value of the investment
• Number of years of investment

Once you provide this data, the calculator automatically tells you the compounded annual growth rate of the investment.

8. CAGR calculator and Mutual Funds

The CAGR calculator is very useful tomutual fund investors. Using this calculator, you can understand how your fund is performing and take necessary investment actions. Here is how a CAGR calculator can help you:

• Better investment decisions: The CAGR calculator is a convenient tool to help you analyze your investment decisions every year. For instance, if you purchased anequity mutual fundfive years ago, the CAGR calculator gives you the average rate of returns you have earned every year over the past five years. This can help you understand whether the fund’s returns are as per your expectations or not. If the fund is not performing well, you may want to reconsider your investment in the future.
• Compare returns between different funds and benchmarks: you can also use the CAGR calculator to compare the returns you earn on a particular fund against similar funds. This can help you understand how well the mutual fund is performing compared to its peers. You can also compare against the benchmark indices for greater clarity.

9. Conclusion

CAGR is a very useful method to calculate the growth rate of an investment. It can be used to evaluate past returns or estimate the future returns of your investments. However, remember that CAGR works suitably for lumpsum investments. In the case ofSystematic Investment Plans (SIPs), it does not take periodic investments into account as it only considers the initial and final values for the calculation. Overall, the CAGR calculator is a very useful tool and it can help you analyze your investments.