Investors are able to measure the rate of return on individual assets, as well as multiple kinds of investments, investment portfolios, or company indicators, using a statistic known as the compound annual growth rate (CAGR).
CAGR Meaning & Definition
The Compound Annual Growth Rate (CAGR) is the annualized growth rate of return of the value of an investment or a financial statistic over a certain number of years while taking compound growth into account. It is also known as the annualized growth rate of return on investment.
The growth rate over a period of years will be different, and it’s even possible that it may be negative. This rate is “smoothed out” using CAGR as if the increase were consistent throughout the course of each year. The only investments with a consistent growth rate are specific deposits and bonds that are kept to maturity.
How CAGR Is Used by Investors
The compound annual growth rate gives investors the ability to accomplish the following:
- Analyze a Single Investment: The compound annual growth rate, or CAGR, is a measure that calculates the average growth rate of a single investment and enables investors to forecast the growth of the investment in the future.
- Compare the Performance of Different Investment Types: The compound annual growth rate (CAGR) is a useful tool for investors because it enables them to compare the returns generated by various forms of investments, such as stocks, bonds, real estate, and savings accounts.
- Compare Two Investments: Investors may compare the growth rates of two assets, such as two stocks, or the growth rate of one stock to the performance of a market index by using a metric called compound annual growth rate (CAGR).
- As a Reality Check on Projections: If a firm were to announce a predicted CAGR of 20%, this would call for an investigation into the CAGRs of the company’s most direct rivals as well as the CAGR of the industry in which the company operates as a whole. If one were considerably different from the other, this may be a cause for concern.
- Compare Business Metrics: The compound annual growth rate (CAGR) is a useful metric for investors to use when analyzing multiple business metrics related to the same company. For instance, the CAGR of the Return on Marketing Investment (ROMI) could be compared with that of the Net Sales Revenue, which is Gross Sales minus Discounts, Returns, and Costs Related to Discounts and Returns.
The following formula may be used to get the CAGR:
CAGR = ([(Ending Value / Beginning Value) ^ (1 / # of years)] – 1) * 100
- Ending Value: Is it the worth of a single investment, the value of a portfolio, or the value of a company statistic as of the end of the time period?
- Beginning Value: Is the value of a single investment, the portfolio as a whole, or a business metric when the time period begins?
- # of Years: Includes half years, which may be turned into full years by counting the number of days in the partial year and then dividing that total by the average number of days in a year, which is 365.
Calculating CAGR for a Portfolio
In order to ascertain the values at the beginning and the conclusion of an investment portfolio:
- For stocks, Find out how much each share was selling for at the beginning of the period, then multiply that figure by the total number of shares. Carry out the same action with the closing date.
- For certificates of deposit, You may either use the value that they will have at maturity, or you can contact the issuer of the certificates to find out what their present worth is.
- For a 401k, Look at the beginning and finishing statements of the transaction, or go into the online account, to find out what the starting and ending values are.
To calculate the initial value of the portfolio, add up all of the individual starting values, and to estimate its finishing value, add up all of the individual ending values. The next step is to calculate the number of years that have passed since those two dates. Be careful to add any quarterly dividends that were earned during the time period, as well as any taxes, fines, or penalties that would be charged as a result of selling stock, cashing out an individual retirement account (IRA), or liquidating any other assets. When selling stocks, some brokers may charge a commission or a transaction fee. Additionally, investors may be responsible for paying capital gains taxes on any sales they make.
Let’s say a certain Mr. Smith put $10,000 into a portfolio on January 1, 2018, and he tracked the returns on his investment over the subsequent four years:
Mr. Smith’s Portfolio:
|Date||Amount||Rate of Return|
The growth rates of Mr. Smith’s portfolio from one year to the next fluctuated dramatically, from 45% in the first year down to 4.8% in the second year, before recovering during years three and four. This is something that is quite easy to understand. The compound annual growth rate (CAGR) gives us information on the average yearly growth rate of Mr. Smith’s portfolio over the course of all four years:
CAGR = ([($26,100/$14,500) ^ 1/4]- 1) * 100 = 15.83%
Calculating CAGR for a Single Investment
To calculate the compound annual growth rate (CAGR) for a single investment, first, determine the value of the investment on the beginning date, then find the value of the investment on the ending date, and then determine the number of years that have passed since the starting date.
Imagine that on January 1, 2018, Mr. Smith spent $10,016.60 to purchase 116 shares of Microsoft Corporation (MSFT) at an average price of $86.35. On January 1, 2022, one share of Microsoft was selling for $329.09, resulting in a dividend payment of $38,174.44. Calculating the compound annual growth rate (CAGR) of Mr. Smith’s investment in Microsoft over the course of four years looks like this:
CAGR = ([($38,174.44 / 10,016.60) ^ 1/4] – 1) * 100 = 39.62%
Calculating CAGR in Excel/Sheets
Investors may calculate any of the three inputs into the CAGR calculation by using a spreadsheet program like Excel, which is available to them.
An ending value
A beginning value
The amount of time in years
Excel does not have a dedicated function for calculating CAGR, but its pre-programmed RRI function may be used in its place, as seen in the following example:
In addition, one has the option of manually entering the CAGR formula, which is as follows:
Calculating CAGR for Partial Years
In practice, investors do not keep their money in the same account for a constant period of time. For instance, if an investment of $10,000 was made on Wednesday, July 11, 2018, and the stock was sold on Monday, June 6, 2022, for a price of $18,901, the investor would have held onto the stock for a total of 1,426 days before selling it.
To calculate the CAGR:
1,426 / 365 days per year = 3.91 years
CAGR = ([($18,901/$10,000) ^ 1/3.91] – 1) * 100
Limitations of CAGR
- Portfolio Additions or Withdrawals: If an investor adds money to his portfolio, it will result in an inflated CAGR, but if he deletes funds from his portfolio, it will result in a deflated CAGR. The compound annual growth rate (CAGR) for a portfolio does not take into account any account additions or withdrawals.
- Actual CAGR Differing From Expected CAGRWhen looking at data over a shorter period of time, the actual compound annual growth rate may be different from the predicted CAGR. This is due to the fact that the projected rates of return may not be consistent with those seen in the past. This might result in an increase in the value of the investment that was not created by performance; nevertheless, the compound annual growth rate does not take into consideration elements in the change in value that are not connected to performance.
Because it is one of the most accurate ways to calculate the returns of an individual asset, an investment portfolio containing multiple assets, or really any asset whose value can rise or fall over time, knowing what the CAGR is and how it is calculated is invaluable information for investors. This is because the CAGR is one of the most accurate ways to calculate the returns of an individual asset.
What’s the difference between CAGR and annualized return?
- The average annual growth rate, often known as AAGR, is a linear metric that does not take into account the effect of compounding. The compound annual growth rate (CAGR) is a statistic that takes into account compounding, is exponential in nature, and smoothes out the returns on an investment over a period of time, so reducing the impact of return volatility.
What does 3-year CAGR mean?
- The three-year compounded annual growth rate of an investment, such as a stock, is referred to as the three-year CAGR. This growth rate is calculated by adding the increase in the share price over the course of the three-year period to any dividends that were paid on the shares during that time.
What’s the difference between IRR and CAGR?
- The compound annual growth rate (CAGR) takes into account just the initial and final values of an investment, but the internal rate of return (IRR) takes into account cash inflows and outflows that continually occur in investments. The internal rate of return (IRR) is often regarded to be a superior metric to the compound annual growth rate (CAGR) in circumstances when there are numerous cash flows.