What Is Compound Annual Growth Rate (CAGR)?
To coincide with the launch of my CAGR calculator, Robert George takes a look at what CAGR is and how it is calculated.
Compound annual growth rate (CAGR) is a business and investment term that is used to refer to the mean annual growth rate of an investment over a certain period of time, usually longer than one year. It can be explained as a measure of growth of an investment based on the assumption that the investment grows in terms of value on a steady rate, compounded annually.
The compound annual growth rate value gets an investor from the initial value of an investment to the final value of the investment over a specified duration of time. However, this is only a hypothetical value which does not account for volatility. The calculation of the compound annual growth rate for an investment is easy provided that the present value and expected future value of the investment are known, as well as the duration (years) in which the investment attains the future investment value.
How to calculate CAGR
To recap, in order to obtain the compound annual growth rate (CAGR) of an investment, you require the following:
- Present value (PV)
- Future value (FV)
- Duration in years (n)
To make the calculation, divide the future value of the investment (FV) by the present value (PV), raise the result to the power of one divided by the specified duration (n), and subtract one from the subsequent result.
The formula for calculating compound annual growth rate is:
CAGR = (FV / PV) (1 / n) -1
Or, using the ^ symbol for 'to the power of':
CAGR = [(FV / PV) ^ (1 / n)] -1
CAGR example calculation
Consider a company that makes an initial investment of $10M in the year 2000. If the value of the investment by 2005 is $15M, then the rate of the investment will be calculated as follows:
- Present value (PV) = 10
- Future value (FV) = 15
- Duration in years (n) = 5
[(15/10) ^ (1/5)] -1
This gives us:
[1.5 ^ 0.2] - 1 = 0.084.
This translates into a compound annual growth rate of 8.4%.
In some cases, however, the calculation of the compound annual growth rate can be more complex than the above example and thus there is a need for a financial calculator. The CAGR calculator on this website is a helpful tool for an investor when evaluating investment progress and goals.
How useful is CAGR?
Despite the availability of other measures of growth, such as annual return rate of an investment, the Compound Annual Growth Rate is considered a better measure of an investment's progress in terms of growth. This is because the annual return rate disregards the effects of compounding and thus may lead to an overestimate of the growth of the investment. The Compound Annual Growth Rate is a geometric average that represents a more reliable growth rate of an investment.
The compound annual growth rate is a simple metric that has a variety of uses. The rate can be used to determine the average growth rate of a single investment. There are various factors in the market that can influence the growth rate of an investment, thus making it difficult to interpret the year to year growth. Thus the CAGR may be used to give a clarification on the progress of an investment. The rate can also be used to compare the growth of more than one investment.
Comparing the rate of different investments given that the number of years is the same, allows an investor to determine which investment has a higher growth rate. For instance, an investor might have various investment options to consider when investing. Comparing the annual rate of the various investment options allows the investor to choose an investment that will be more desirable in terms of growth. The compound annual growth rate can also be used to track the performance of various investment measures of one or multiple investments alongside one another. The comparison of various Compound Annual Growth Rate measures may help reveal an investment's strengths and weaknesses. In addition to that, comparing the Compound Annual Growth Rate measures of an investment with those of other investments helps to determine its performance in the market.
Limitations of CAGR
One of the greatest limitations of the compound annual growth rate is that it ignores volatility. In reality this is never the case and thus it is not advisable to use CAGR as the only metric to determine the growth rate of an investment. The compound annual growth rate cannot also be considered as a reliable forecast of growth because no matter how steady the growth rate of an investment has been in the past, it is not guaranteed that this will be the case in the future because of other factors in the market that affect the growth rate of an investment.
Written by Robert George
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