Top Stories | Wed, 11 Dec 2024 10:23 AM

Why CAGR Matters: Unlocking the Secrets of Investment Growth

Posted by : SHALINI SHARMA

The compound annual growth rate is the investment returns needed every year for balancing an investment from the beginning amount to the end amount over a certain course of time. However, during this entire life span of an investment, the CAGR also assumes that any profits would be reinvested at the end of each investment period.

How to Calculate Compound Annual Growth Rate (CAGR)

 CAGR = ((BV/EV ) ^1/n − 1) × 100

where: EV = Ending value

            BV = Beginning value

           N = Number of years

Key Objectives: 

•The compounded annual growth rate (CAGR) is one of the most accurate ways of calculating and determining returns on anything that can either grow in value or depreciate.

•A rate of return that is smoothed over time is indicated. To make possible comparisons, the investor can place the CAGR of two or more investments side by side to evaluate how well one has performed compared with other investments in a peer group or market index.

•The different investments' performances are thus well compared against a particular time frame, benchmark, or another. However, a lot of discussion about the investment risk is not captured by the CAGR.

Example of How to Use CAGR

Imagine you invested $10,000 in a portfolio with the returns outlined below:

•From Jan. 1, 2018, to Jan. 1, 2019, your portfolio grew to $13,000 (or 30% in year one).

•On Jan. 1, 2020, the portfolio was $14,000 (or 7.69% from January 2019 to January 2020).

•On Jan. 1, 2021, the portfolio ended with $19,000 (or 35.71% from January 2020 to January 2021).

CAGR= (($10,000$19,000) ^1/3 −1) × 100

         =23.86%

 CAGR over that period was 23.86% 

Questions & answers on CAGR

1. What is meant by CAGR?

 CAGR refers to a Computed Annual Growth Rate, and it is a metric that reflects the annualized growth rate of an investment, business, or metric over a given length of time under the assumption that such growth has occurred at a constant rate.

2. How is CAGR calculated?

The formula for CAGR is:

CAGR = ((BV/EV ) ^1/n − 1) × 100

3. What is the importance of CAGR?

 CAGR is important in that it presents anything smooth in annual growth rate without the influences of volatility and as such is good for making comparisons between the performances of investments or the growths of business entities over time.

4. What does a high CAGR indicate?

 A higher CAGR shows that investment or business metric has performed very well regarding its value for the observed period.

5. Can there be negative CAGR?

 Yes, given a situation whereby the ending value is less than the beginning value, there is a decline over the period, and thus negative CAGR results.

6. In what fields CAGR is widely instituted?

 CAGR is widely instituted in fields like finance and investment, business performance evaluation, market forecasting, and revenue growth assessment. 

7. What is the difference between absolute growth and CAGR?

 Whereas absolute growth signifies the total increase in value over a time period, CAGR indicates annualized growth rate as if growth had occurred uniformly each year.

8. Is CAGR for short time analysis?

 CAGR holds more relevance in a long-term study (for example, beyond three years) as it assumes consistent growth, which may not be reflected while looking at the short term due to.

9. What are the limitations of CAGR?

Assumes constant growth rate, which may not reflect actual changes in the real world. Year-over-year performance or volatility is not revealed. Any cash flows throughout the time period have no bearing on compounding.

10. How can CAGR be applied in market analysis?

 It's responsible for evaluating the growth of market segments, comparisons of performance across industries, future trend analogy, and measuring revenues, profits, or market share of the companies over time.