A handy method for evaluating the performance of long-term investments.
Table of Contents
- What is the Compound Annual Growth Rate (CAGR)?
- How to calculate CAGR?
- CAGR formula
- Illustrating CAGR with an Example
- The Impact of Time Horizon on CAGR
- Pros and Cons of CAGR
- Advantages of CAGR
- Limitations of CAGR
- Similar tools
- CAGR vs. Simple Annual Growth Rate (SAGR):
- CAGR vs. Return on Investment (ROI):
- CAGR vs. Average Rate of Return (ARR):
- CAGR vs. Internal Rate of Return (IRR):
- CAGR vs. Absolute Return:
What is the Compound Annual Growth Rate (CAGR)?
The compound Annual Growth Rate is a metric of the average annual growth rate over a given period. Typically CAGR is calculated for several years.
CAGR is very useful for evaluating the profitability of investments over a long period. It helps to compare investments with different time frames by reducing the return rate to a common denominator - in this case, average annual growth.
This metric is usually presented as a percentage value, but a ratio is also valid but less common.
Since not all investments are profitable, the CAGR may take positive or negative values.
Due to its simplicity, this metric is widely used across various investment types, from stocks and mutual funds to business analysis and real estate.
How to calculate CAGR?
In order to calculate the CAGR, you need to follow the following procedure.
- Gather the investment data: starting value, final value, and time of investments in years.
- Substitute values to the CAGR formula below.
In order to calculate the Compound Annual Growth Rate, use the following equation:
Vf - value at the end of the investment
Vb - value at the beginning of the investment
t - the number of years
Illustrating CAGR with an Example
To grasp the concept of how to calculate the compound annual growth rate (CAGR), let's walk through a practical example.
Suppose you made an initial investment of $1,000 in a promising stock. By the end of a 5-year investment period, the value of the investment has appreciated to $2,000.
Total Return Over the Investment Period:
Before diving into the CAGR, let's first determine the total return from the entire period.
- Initial investment value: $1,000
- Value at the end of the investment period: $2,000
- Total Return = (Final Investment Value - Initial Investment Value) / Initial Investment Value
- Total Return = ($2,000 - $1,000) / $1,000 = 1 or 100%
This means that over the 5-year period, your investment value doubled, giving you a total return of 100%.
Step-by-Step CAGR Calculation:
Now, let's calculate the compound annual growth rate for this investment.
- CAGR = [(Final Value / Initial Value)^(1/Number of Years)] - 1
- Plugging in our values: CAGR = [(2,000 / 1,000)^(1/5)] - 1
- CAGR = 2^(1/5) - 1
- CAGR ≈ 14.87%
This calculation indicates that the average growth of your investment value over the 5-year period is 14.87% per year.
For those who prefer a more straightforward approach without manual calculations, we created this online CAGR calculator. By inputting your initial and final investment values and the duration of the investment period, these tools can instantly provide the CAGR return.
Interpreting the Result: While the total return over the 5 years was 100%, the CAGR tells us that the investment value grew at an average growth rate of 17.4% annually. A CAGR of 17.4% is often considered a good CAGR in many investment scenarios.
However, it's essential to remember that CAGR represents the average growth and doesn't account for year-to-year volatility.
The Impact of Time Horizon on CAGR
The Compound Annual Growth Rate (CAGR) is influenced by the duration over which it's calculated. A longer time horizon can often result in a lower CAGR, even if the absolute growth remains the same. This is because the compounding effect is spread out over more years.
Let's consider an investment that grows from $1000 to $2000. We'll calculate the CAGR for time horizons of 5, 10, and 15 years:
- 5 years: CAGR = 14.87%
- 10 years: CAGR = 7.18%
- 15 years: CAGR = 4.73%
Now, let's visualize these CAGR values over different time horizons in a bar chart.
As depicted in the chart. The CAGR decreases as the time horizon increases, even if the absolute growth remains constant. This highlights the importance of considering the investment duration when evaluating returns.
Pros and Cons of CAGR
Although CAGR is a handy financial indicator, it has its limitations you need to be aware of in order to interpret the results correctly.
First, let's start with the benefits of this metric.
Advantages of CAGR
Here are the primary advantages of using CAGR:
Simplicity: One of the main benefits of CAGR is its straightforwardness. With just the initial and final values of your investment and the duration, you can use the CAGR calculator to determine the average yearly growth rate. This simplicity makes it accessible even to novice investors.
- Uniform Measure of Growth: CAGR provides a consistent measure of growth, allowing investors to compare the performance of different investments over a certain time. This uniformity makes it easier to evaluate and contrast various investment opportunities.
Eliminates Short-Term Fluctuations: Unlike monthly growth rates or other short-term metrics, CAGR focuses on the bigger picture. It gives an average growth rate that eliminates the noise of short-term volatility, offering a clearer indicator of growth over an extended period.
Facilitates Comparisons: Whether you're comparing investments over a period of 3 years or 10 years, CAGR provides a standardized metric. This makes it easier to compare the value of your investment or the total growth against other investments or benchmarks.
Versatile Application: CAGR isn't just limited to yearly evaluations. It can be used to calculate the growth rate of an investment over a certain time, be it monthly, quarterly, or any other time frame, making it a versatile tool in an investor's toolkit.
Holistic View: CAGR offers a more holistic view of an investment's performance. Instead of focusing on individual peaks and troughs, it provides an average, which can be a more accurate representation of an investment's health and potential.
CAGR is widely used for a reason: it serves as a reliable and consistent indicator of growth, allowing investors to gauge the average yearly growth of an investment over a period. Whether you're using manual calculations or opting to calculate CAGR online, this metric provides valuable insights into the total growth and potential trajectory of your investments.
Limitations of CAGR
The Compound Annual Growth Rate (CAGR) is a widely used metric that provides investors with a smoothed average rate of return over a specific period. While it offers a simplified view of the growth rate of an investment, it's essential to understand its limitations:
Doesn't Reflect Volatility: One of the most significant limitations of CAGR is that it only considers the beginning and end value of an investment, ignoring the journey in between. This means that CAGR doesn't capture the volatility or fluctuations in annual returns. Two investments might have the same CAGR but vastly different levels of risk and volatility.
Assumes Compound Growth: CAGR assumes that the investment grows at a steady compound growth rate every year, which is rarely the case in real-world scenarios. Investments often have varying rates of return from one year to the next.
Not Ideal for Short Durations: While CAGR can provide insights into the average rate of return for an investment over a certain period, it might not be as accurate or useful for very short durations. The growth rate of an investment over a short period can be significantly influenced by temporary market conditions.
Can Be Misleading: Since CAGR provides an average, it can sometimes paint an overly optimistic or pessimistic picture. For instance, if an investment suffered significant losses in the early years but had a strong rebound in the latter years, the CAGR might suggest a more stable and consistent growth than what truly transpired.
Doesn't Account for External Factors: CAGR doesn't consider external factors like inflation, which can impact the real future value of the investment. An investment might have a positive CAGR, but when adjusted for inflation, the real rate of return might be less impressive.
Dependency on Accurate Inputs: Like any formula, the accuracy of CAGR is dependent on the accuracy of its inputs. If there are errors in the initial or end value of the investment, it will lead to a skewed compound annual growth rate.
For those seeking a more detailed and nuanced understanding of their investments, it might be beneficial to use the compound annual growth rate online tools in conjunction with other financial metrics.
This comprehensive approach ensures that investors get a holistic view of their investment return, considering both the average growth and the intricacies of annual returns.
If you plan a serious investment strategy, Calcopolis is suitable for you. On our website, you will find many tools that help you double-check your investments.
The starting point should be investing calculators category page; you will find there a few dozens of online tools that will help you calculate the profitability of various investments.
CAGR vs. Simple Annual Growth Rate (SAGR):
CAGR Value: Represents the effective annual rate that provides a smoothed average growth rate over time, taking into account the compounding effect.
SAGR: Offers a straightforward average of yearly growth rates without considering the compounding effect, which might not reflect the true return on an investment over multiple periods.
CAGR vs. Return on Investment (ROI):
CAGR: Focuses on the average growth rate over a specific duration, often calculated using a CAGR return calculator.
ROI (Return on Investment): Measures the total percentage return of an investment relative to its initial cost. It provides a snapshot of the profitability but doesn't break it down into an annualized rate.
CAGR vs. Average Rate of Return (ARR):
CAGR: Gives a consistent annual growth rate, emphasizing the compounding effect.
ARR: Calculates the arithmetic mean of periodic returns, not taking into account the compounding effect, which might lead to a different perspective on the investment's performance.
CAGR vs. Internal Rate of Return (IRR):
CAGR: Primarily considers the initial and final values of an investment.
IRR: Evaluates all cash flows of an investment, pinpointing the discount rate where the net present value (NPV) of these cash flows is zero. This is especially useful for investments with varied cash inflows and outflows, offering a more comprehensive view. For more information, visit our IRR calculator or XIRR calculator.
CAGR vs. Absolute Return:
CAGR: Provides an annualized perspective on the growth of an investment.
Absolute Return: Focuses on the total growth from the beginning to the end of the investment period without annualizing it.