What Is Compound Annual Growth Rate
The compound annual growth rate is the rate of return on investments for a specific period. CAGR is the best way to calculate the accurate rise and fall in investment as it finds the rate of return and helps in the comparison of multiple stocks. With CAGR, a person can see which stock did the best in the market index and even judge the best way to invest. You can compare overall investment and year-end investment growth. But it must be noted that it does not reflect the risks of investments.
Purpose and Meaning of CAGR
The main purpose is to define the profit earned from investment. The compound annual growth rate helps one make a sound financial decision. It tells you the growing distance between the whole year and the year-end investment. However, the right investment provides a profit at the end of the year. The compound annual growth rate is better for smooth results.
How to Calculate Compound Annual Growth Rate
Anyone can calculate the compound annual growth rate using the formula below:
CAGR = [(EV/BV) 1/N – 1) X 100
Where:
EV stands for ending value
RV stands for beginning value
n stands for the number of years
You can follow these instructions for CAGR calculation:
- Calculate the ending value with the starting value
- Divide the result by the number of years
- Subtract the result from 1
- Multiply the result by 100 to convert it into a percentage
Examples of Compound Annual Growth Rate
The example is based on assumptions. Let’s assume the investment is $10,000 in a portfolio with the below-mentioned returns:
- From 01 January 2017 to 01 January 2018, the portfolio grew by $3,000. That is a 30% growth in one year ($10,000 to $13,000).
- On January 1, 2019, the portfolio was raised to $14,000 (a 7.69% rise in one year).
- On January 1, 2020, the portfolio was raised to $19,000 (a 35.69% rise in one year).
You can see the low growth rate in 2018-19. But it rose in 2019–2020 using compound annual growth rates. The overall CAGR is 28.86% and can be calculated using this formula:
CAGR = ($19000/$10000)1/3-1 X 100 = 23.86%
This compound annual growth rate can help in future decisions. Any investor can compare shares or bonds and can assess rises and falls. For example, if one share is rising and another is falling, the investor can use the compound annual growth rate and smooth the movement. They may invest or choose to take the risk.
Here is another example:
Mr. A bought 55 shares in January 2018 at $1,100 per share. The total investment is $60,500. After 3 years, in January 2021, the current price per share will be $3,200. Now the investment is $176,000.
The calculation using the formula is:
Starting amount = $60,500
Ending amount = $176,000
Number of years = 3
CAGR = [(176000/60500)^(1/3)-1 = 35.69
This is how to calculate CAGR on investment.
Additional Uses of the Compound Annual Growth Rate
These are some of the additional uses of the compound annual growth rate:
- CAGR can calculate the return on single investments.
- CAGR can smooth the return in an inconsistent growth period and help in steadying growth.
- CAGR can predict changes and save the investor’s money with the right calculations.
Track Performance With CAGR
Compound annual growth rates can track performance. You can use the formula with the starting and ending investment amounts and the number of years to get the result in percentage form. For example, a five-year period of supermarket sales shares using CAGR is 1.82%. But customer satisfaction is -0.55%. In this way, the compound annual growth rate can show the highs and lows of a company.
Detect Strengths and Weaknesses Using CAGR
You can calculate the CAGR of other companies, compare them, and predict their rate of return. This practice will help you find the strengths and weaknesses of a competitor. You can raise your returns with positive measures, provide the best services to customers, raise your share value, and help you earn extra returns on your investment.
How Do Investors Use CAGR
The investor uses the compound annual growth rate to assess returns. The formula calculates past and present returns and helps predict future gains and losses. The calculation can turn a complex history into a simple percentage. It helps with comparison and improves decision-making.
Here is an example:
Suppose an investor needs $55,000. He gave me $15,000 to invest for the best returns. So, how much is the rate of return to turn $15,000 into $55,000? Investors will use this formula to find the answer.
CAGR = [(55000/15000) – 1 x 100 = 5.66%
The investor has used the formula to find the returns. Now, the investor is free to compare and invest.
What Is a Good Compound Annual Growth Rate
Every investor uses a different context for CAGR calculations. Mostly they use two factors: opportunity cost and risk in the investment, and these two factors are important for good returns on investment. For example, a company’s industry rate is 30%, but its CAGR is 35%. But another company’s industry rate is 10%, and the compound annual growth rate is higher. In general, a higher CAGR brings higher returns on investment. The CAGR may go into negative numbers, and this indicates a loss in investment.
Conclusion
The compound annual growth rate helps assess return earnings over investments and helps in the return calculation for a specific period. It can compare past and present performance and also help predict future rises and falls to save investors from losses. The compound annual growth rate might not be 100% accurate but it does provide an idea of investment decisions. You can reverse the formula and get your desired results as well. For more information on the meaning of CAGR, visit Piramal Finance for similar articles and more information and guidance.