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What is CAGR?
Compound annual growth rate (CAGR) is a business and investment term that is used to refer to the average 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's value grows at a steady rate, compounded annually.
To put it more simply, CAGR represents the interest rate that gets you from the present value to the future value over a specified time period, taking into account for interest compounding. However, this is only a hypothetical value which does not account for volatility. This means that in reality the growth rate in each year may be higher or lower than the CAGR.
Calculating 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 its future value.
How to calculate CAGR
To calculate CAGR, 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 then subtract one from the result.
In order to calculate the compound annual growth rate (CAGR) of an investment, you require the following:
- Present value (PV)
- Future value (FV)
- Duration in years (n)
Step by step
- Take the future investment value (FV) and divide it by its present value (PV).
- Raise the resulting figure to the power of 1 divided by the number of years the investment is for (n).
- Subtract 1 from the result.
Formula for CAGR
- FV = the future value of the investment
- PV = the present value of the investment
- n = the number of years
CAGR example calculation
Consider a company that makes an initial investment of $100,000 in the year 2000. If the value of the investment by 2005 is $150,000, then the rate of the investment can be calculated as follows:
- Present value (PV) = 100000
- Future value (FV) = 150000
- Duration in years (n) = 5
Adding these into our formula
CAGR = [(FV / PV) ^ (1 / n)] -1
CAGR = [(150000/100000) ^ (1/5)] -1
This gives us:
[1.5 ^ 0.2] - 1 = 0.0845.
Our CAGR is therefore 8.45%.
Chart of fixed-rate growth
With fixed-rate growth of 8.45% per year, the chart of growth might look like this...
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 CAGR is a geometric average that represents a more reliable growth rate of an 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. Consequently, 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 of their investments has a higher growth rate. If someone has a range of different options to consider, comparing the CAGR of each investment option allows the person to choose one 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 CAGR measures may help reveal an investment's strengths and weaknesses. In addition to that, comparing the CAGR measure of an investment with those of other investments helps to determine its performance in the market.
It's worth noting that CAGR can sometimes be referred to as the annualized rate of return, effective annual rate or annual percent yield.
Limitations of CAGR
One of the greatest limitations of the compound annual growth rate is that it ignores volatility. In reality, CAGR hides the fact that your investment return could be much higher or much lower in an individual year, which can come as a big shock to a new investor experiencing those highs and lows for the first time. Thus, it is not advisable to use CAGR as the only metric to determine an investment's performance.
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, due to a range of different market factors.
CAGR and IRR
CAGR and IRR are both measues of return on an investment over a period of time. IRR is said to be a more flexible way of calculating investment performance, as it allows for multiple cash flows.
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