CAGR (Compound Annual Growth Rate)

What Is CAGR?

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.

The Formula for CAGR

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

Where:

Ending Value: The final value of the investment or metric.
Beginning Value: The initial value of the investment or metric.
n: The number of years.

Example Calculation

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

Calculation:

CAGR = ($16,105 / $10,000)^(1/5) – 1

Simplifying:

CAGR = 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.

Why Does CAGR Matter?

CAGR is an important metric for several reasons:

It smooths out volatility: Real growth is often uneven, but CAGR gives you a steady rate.
It allows for easy comparison: You can compare investments with different time frames.
It accounts for compounding: Unlike simple averages, CAGR considers the effects of compounding.
It’s widely used: From stock returns to GDP growth, CAGR is a common metric in finance.

Applications of CAGR

CAGR is used in various contexts, including:

Investment Returns: Measure the performance of stocks, bonds, or portfolios.
Revenue Growth: Track business growth over time.
Market Size Projections: Forecast industry or market growth.
Population Growth: Analyze demographic trends.

Limitations of CAGR

While useful, CAGR has some limitations:

Assumes steady growth: Real growth is often uneven.
Doesn’t show volatility or risk: It provides a smooth rate but omits ups and downs.
Can be misleading: If the start or end point is unusual, CAGR might not reflect typical performance.

CAGR vs. Simple Average

Here’s an example to illustrate why CAGR can be more useful than a simple average:

Investment A:

Year 1: 20% growth
Year 2: -10% growth
Year 3: 40% growth

Investment B: Steady 15% growth each year

Simple Average Growth: Both investments have the same simple average growth of 16.67%, but their CAGRs differ:

Investment A CAGR: 14.87%
Investment B CAGR: 15%

CAGR reveals that despite the volatility, Investment A actually performed slightly worse overall.