A handy method for evaluating the performance of long-term investments.
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:
CAGR = (Vf / Vb)1/t - 1
Vf - value at the end of the investment
Vb - value at the beginning of the investment
t - the number of years
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
- It is a straightforward metric, easy to understand even by newbie investors.
- It is a universal metric that could be applied to any investment type.
- It could be used to analyze investments with different time horizons.
- It requires just three input values, and all the data is easy to find.
Limitations of CAGR
CAGR has one serious disadvantage. Since the result of the CAGR formula is just an average return over a long time, it hides the volatility of the investments.
What's more, calculating the CAGR for assets with high volatility may be misleading for a short period. For example, the CAGR of investment in stocks for three years may give different results during economic prosperity compared to an economic downturn.
But for example, if you calculate the CAGR of long-term investment in an ETF for the last 30 years, the result is much more accurate.
Of course, there are investments when the CAGR for a short period could be applied, like bonds, property rentals, SaaS, etc.
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.
The most popular ones are the ROI calculator and the EBIT calculator. Still, there are also several specialistic tools that are difficult to find elsewhere, for example, the WACC calculator and ROAS calculator.