Compound Annual Growth Rate (CAGR) is a financial metric that represents the average annual growth rate of an investment over a specified period, assuming the profits are reinvested at the end of each year. It’s a useful tool for comparing the performance of different investments or tracking the growth of a single investment over time.
What is CAGR?
CAGR provides a smoothed annual rate of return, eliminating the effects of volatility and fluctuations in periodic returns. It answers the question: “What constant annual growth rate would take an investment from its beginning value to its ending value over a given period?”
CAGR Formula
The formula to calculate CAGR is:
CAGR = (Ending Value / Beginning Value)^(1 / Number of Years) – 1
Where:
- Ending Value: The value of the investment at the end of the period.
- Beginning Value: The value of the investment at the start of the period.
- Number of Years: The total number of years over which the investment is held.
Example Calculation
Suppose you invested ₹10,000 in a mutual fund, and after 5 years, your investment grew to ₹16,105.
Using the CAGR formula:
CAGR = (₹16,105 / ₹10,000)^(1 / 5) – 1
CAGR = (1.6105)^(0.2) – 1
CAGR ≈ 0.10 or 10%
This means your investment grew at an average rate of 10% per year over the 5-year period.
Why Use CAGR?
- Simplicity: Provides a single annual growth rate, making it easier to compare different investments.
- Compounding: Accounts for the effect of compounding, offering a more accurate picture of investment growth.
- Comparison: Useful for comparing the performance of various investments over the same time frame.
Limitations of CAGR
- Ignores Volatility: CAGR assumes a steady growth rate and doesn’t reflect the investment’s volatility or fluctuations during the period.
- No Interim Data: Doesn’t account for any interim cash flows, such as additional investments or withdrawals.
- Not Predictive: Past CAGR doesn’t guarantee future returns.
Calculating CAGR in Excel
In Microsoft Excel, you can calculate CAGR using the formula:
= (Ending Value / Beginning Value) ^ (1 / Number of Years) - 1
Alternatively, Excel’s RRI function can be used:
= RRI(Number of Years, Beginning Value, Ending Value)
Conclusion
CAGR is a valuable metric for assessing the average annual growth rate of an investment over time. While it simplifies the growth rate into a single figure, it’s essential to consider its limitations and use it alongside other financial metrics for a comprehensive analysis.
