The Compounded Annual Growth Rate (CAGR) is one of the finer measures to assess fund performance. It is the rate of return that would be required for the investment value to grow from the principal value or the base value to its final value when the profits or returns from the investment are reinvested and not redeemed.
The Compounded Annual Growth Rate is one of the most accurate measures of returns and is often used to compare relatable investments as market indices, shares, mutual fund schemes, etc. It gives a fairer picture of the performance of the investment taking into account the time for which the investment has been made.
Calculation of the Compounded Annual Growth Rate is done by using the following formula –
R= ((A/P)^1/n-1), where,
R is the Compounded Annual Growth Rate
A is the final value of Investment
P is the initial value of investment or the principal investment and
N is the Period for which the Investment is made
To calculate the CAGR, we follow the following steps –
- Divide the Final value of the investment by the Initial Value
- We then raise the value derived in step (a) to an exponent of 1 divided by the number of years
- From (b) we then subtract 1
The final result that is arrived at by following the above steps is the Compounded Annual Growth Rate of the Investment.
The Compounded Annual Growth Rate is not an actual return figure but a figure that represents the value that investment would have grown to if it had grown at the same rate with profits from returns being reinvested. This is not how an investment grows in reality but as a measure of return comparison, it does iron out the returns so that alternative investments can be compared in a more comprehensible manner.
Just to illustrate this with the help of an example, if you invest Rs.10000 in a fund and it becomes Rs.12500 at the end of year 1 which means a return of 25%. This amount then grows to Rs.13500 at the end of year 2 which means a return of 8% for year 2. At the end of 3 years, the investment grows to Rs.15000 which equates to a return of 11% for this year.
From the above, it can be seen that the year-to-year return rates from this investment is different.
On the other hand, the Compounded annual growth rate of the investment from start year to the end of 3 years would be 14.47% calculated as given hereunder –
R= ((15000/10000)^1/3)-1=14.47%
The return of 14.47% is the uniform annual growth rate of the investment year on year for the 3 years and it completely ignores the individual year-wise returns or investment performance of this fund. CAGR comes as a more useful measure of comparison while comparing avenues with low correlation or no correlation at all. The Compounded Annual Growth Rate (CAGR) becomes a preferred way when comparing such investments as it smoothens the annual return over the period making it easier to compare such investments.
The Compounded Annual Growth Rate is a highly preferred parameter for volatile investments such as equity-oriented avenues of stocks and mutual funds. Due to the volatility parameter, the returns from such avenues are very erratic and uncertain. THE CAGR smoothens out this volatility as is a much more consistent measure for assessing returns from such investments.
As a measure of returns, the Compounded Annual Growth Rate is a preferred measure when assessing investment performance over a longer time or when assessing the long term growth of a company. The short term variations get ruled out when using the Compounded Annual Growth Rate. The unsystematic risk or market risk or risk attributed to other economic factors associated with equities gets eliminated when using CAGR. This helps one to understand the individual company, stock, or fund performance and the strength of the intrinsic factors governing the investment in question.
While the Short Term Compounded Annual Growth Rate incorporates the different underlying parameters affecting the investment performance including the market factors, the annualized CAGR does not.
For extended periods, the Compounded annual growth rate rules out the short-term variations that are caused because of these market factors as the fund or stock recovers from these and thus it reflects upon the true growth potential of the investment in question.
Like every other measure, there are a few limitations attributed to CAGR too, and these are enumerated below -
- It completely ignores the market ups & downs – This has been very vividly explained above where the varying investment performance in the different years gets ruled out as we calculate the Compounded annual growth rate of the investment in question.
- The Compounded Annual Growth Rate does not take into account the risk parameter too which is highly important when analysing the investment performance and also when comparing one against the other.
To make a more comprehensive comparison, it is advised that one makes use of the other alternate measures too. The Internal Rate of Return, Sharpe Ratio, XIRR are some of these other factors that when taken into account along with the Compounded Annual Growth Rate aid in making a wider comparison and in turn facilitate the right decision making when choosing to invest.
The Internal Rate of return takes into account the concept of discounting the future cash flows and also the Net Present Value when assessing the investment performance or profitability. An internal rate of return higher than the expected value augurs well for the investment performance and is an indicator of higher profits one may make when investing. The shape ratio, on the other hand, is another meaningful alternate measure that is calculated by dividing the difference between the average rate of return and the risk-free rate by the standard deviation. The risk-free rate will ideally be the rate of return that one would earn if this sum of money was invested in bank fixed deposits. The standard deviation takes into account the past performance of the investment in question and reflects upon the difference of the actual return from a benchmark or expected returns.
The Sharpe ratio and CAGR when used together give a more holistic view of the investment, fund, stock in terms of expected return and the associated risk with it.
Conclusion
To sum it up, the Compounded Annual Growth Rate remains one of the most popular measures of investment analysis but it should always be used with a pinch of salt as it does not reflect upon investment risk which is a very crucial aspect when analysing investment, fund or stock performance.
People often ask
- What does 3 year CAGR mean?
- Why CAGR is better than average?
- Can CAGR be negative?
- How do you calculate CAGR backwards?
- Can you use CAGR for forecasting?
3 year CAGR is the return that an investment should earn on the principal amount to grow to a resultant amount at the end of 3 years. For ex - If you invest Rs.10000 today and want this amount to grow to Rs.15000 at the end of 3 years, the 3 year CAGR will be 14.47%. The other way to look at this is that if you invest Rs.10000 today and the 3 year CAGR is 10%, this amount of Rs.10000 will grow to Rs. 13310. In effect, 3 year CAGR is year on year uniform return that the investment earns where at the end of year 1, the investment amount is the sum of principal amount and return earned and likewise for consecutive years.
CAGR accurately depicts the changing market trends whereas average fails to depict the changing market trends which can be a threat to analysts predicting and studying changing market scenarios.
Yes, CAGR can be negative when the final value of stocks or investments is lower than the initial value of stocks or investments.
The CAGR can be calculated backwards too when you know the principal investment, resultant amount and the time horizon of the investment. The formula used is as follows - ((A/P)^1/n-1), where A is the final amount, P is the principal invested and n is the investment term.
You can use CAGR to understand the future market trends and future value of shares in order to forecast the profitable investments.