CAGR (Compound Annual Growth Rate)

CAGR stands for Compound Annual Growth Rate. It’s a measure that tells you the rate at which an investment would have grown if it grew at a steady rate every year over a specific period. It’s like a financial smoothie blender, turning chunky growth into a silky performance metric.

Here’s the formula (don’t worry, we’ll break it down!):

CAGR = (Ending Value / Beginning Value)^(1/n) – 1

Where n = number of years

👆 By the way, an interesting fact: CAGR is often used in comparing the performance of different investments.

Let’s look at an example:

Imagine you invested $10,000 in a stock, and after 5 years, it’s worth $16,105.

CAGR = ($16,105 / $10,000)^(1/5) – 1 = 1.61^0.2 – 1 = 1.1 – 1 = 0.1 or 10%

This means your investment grew at an average rate of 10% per year over those 5 years.

Now, why does CAGR matter? Here’s why it’s important:

1. It smooths out volatility: Real growth is often uneven, but CAGR gives you a steady rate.

2. It allows for easy comparison: You can compare investments with different time frames.

3. It accounts for compounding: Unlike simple averages, CAGR considers the effects of compounding.

4. It’s widely used: From stock returns to GDP growth, CAGR is a common metric in finance.

CAGR is used in various contexts:

• Investment returns

• Revenue growth in business

• Market size projections

• Population growth

But remember, CAGR isn’t perfect. Here are some limitations:

• It assumes steady growth, which rarely happens in reality.

• It doesn’t show volatility or risk.

• It can be misleading if the start or end point is unusual.

Let’s look at another example to show why CAGR can be more useful than a simple average:

Imagine two investments over 3 years:

Investment A:

• Year 1: 20% growth

• Year 2: -10% growth

• Year 3: 40% growth

Investment B:

• Steady 15% growth each year

Both have the same simple average growth (16.67%), but their CAGRs are different:

• Investment A CAGR: 14.87%

• Investment B CAGR: 15%

CAGR shows that despite the wild ride, Investment A actually performed slightly worse overall!