Table of Contents:
- What does CAGR show?
- How to calculate CAGR
- Whats a good CAGR?
- Limitations of CAGR
- More FAQs about CAGR
- The bottom line
CAGR meaning
What does CAGR mean? The compound annual growth rate, or CAGR, is the annual return on an investment thats calculated by using its initial balance and any interest accumulated over the previous years. What is CAGR in finance? The CAGR formula shows an investment’s accumulated growth each year from its beginning balance to its ending balance and accounts for all profits that are reinvested at the end of each investment period. Lets clarify the CAGR definition by going into more depth on what this formula shows.
Key Takeaways:
- What does CAGR stand for? The CAGR acronym stands for compound annual growth rate.
- What is compound annual growth rate? The compound annual growth rate is the annual growth of an investment over a given period of time.
- The CAGR provides an even or smooth growth rate, meaning that it reflects a rate as if changes occurred equally over a period of time.
- A good CAGR is subjective, meaning that many factors play a role in whether the CAGR is good or bad.
- The CAGR doesnt show the ups and downs of an investment’s performance over a period of time.
- A negative CAGR shows that an investment has decreased over a given period of time rather than increased.
What does CAGR show?
The compound annual growth rate (CAGR) essentially shows how much an investment has grown over time. The CAGR provides an even or smooth growth rate, meaning that it reflects a rate as if changes occurred equally over a period of time. Because of this, the compound annual growth rate is a representational number that shows how much an investment will grow if it were to grow at the same rate and if all profits were reinvested at the end of each year. However, typically the CAGR will not always have the same rate of growth at the end of each year or investment period.
Comparing investments with CAGR
In addition to the compound annual growth rate helping an investor learn about the growth of their investments, it can also be used to compare multiple investment types. The compound annual growth rate is one of the most accurate tools to use to measure historical returns and the returns on any investment value that increases and decreases over a period of time. An investor can also use CAGR to measure a stock’s performance to see how well stocks have performed in comparison to one another.
Lets say that in 2019 you place $1,000 into Investment A for 3 years. You also place an additional $1,000 into Investment B. Although comparing the rate of return for these two investments might be challenging due to your inability to see the volatility of the investments performance over time, using the CAGR to compare these two types of investments can help you gain more insight on the rate of return.
Lets say that at the end of the 3-year period, Investment As balance is $1,191.02
(CAGR = 6%), and Investment Bs balance is $1,442.90 (CAGR = 13%). When looking at the results, you may initially assume that Investment Bs balance has the best return on investment. However, since the compound annual growth rate smooths the returns, you have no way of knowing or seeing the volatility or risks that come with investing in Investment A. While the compound annual growth rate provides an assumed constant growth rate over a period of time, it doesnt guarantee it. Lets expand on this example to get a better understanding by considering two different progressions of returns your $1,000 might have had.
Investment A:
Year 0 |Year 1 |Year 2 |Year 3
$1,000 | $1,518.29 | $2305.22 | $1,191.02
Investment B:
Year 0 |Year 1 |Year 2 |Year 3
$1,000 | $1,001 | $4,000 | $1,442.90
Investment A and B show that the CAGR only takes into account the beginning value and the ending value and doesnt show the possible increases or decreases in your investment over the 3-year period. Since the compound annual growth rate smooths the rate of return, you have no way of knowing how your investments performed in Year 1 and Year 2, and if these time periods presented a gain or loss on profit. This is an essential risk to understand when working with the CAGR formula. Lets take it a step further by looking at an example of a negative CAGR of -4% over a 3-year time period.
Investment C:
Year 0 | Year 1 | Year 2 |Year 3
$1,000 | $1,600 | $1,500 | $884.74
Investment C shows that your initial $1,000 investment had a negative rate of return of -4%. This means that your $1,000 investment decreased in value ending in $883.74 in Year 3.
Using CAGR with other metrics
The CAGR finance formula is a great financial tool that helps investors, and even companies, measure their financial performance or even compare their financial performance to other companies. Ultimately, measuring the CAGR across business metrics within the company and comparing it to other business competitors allows a company to better understand its strengths and weaknesses. Its important to note that CAGR shouldnt be viewed as a stand-alone figure. In other words, the CAGR acts as the measurement of something such as the CAGR of estimated market size or the CAGR of revenue. This can help a company gain insight into its historical performance as well as its future performance, although nothing is ever guaranteed. Lets move on to how to calculate compound annual growth rate.
How to calculate CAGR
The compound annual growth rate formula can be calculated by using Excel, financial calculators, and other CAGR calculators of choice. In addition to using the CAGR equation in Excel, it can also be done by hand using a simple formula. To calculate the compound annual growth rate, use the following formula:
CAGR=(EV/BV)1/n1100
The CAGR formula consists of:
- The ending value (EV) = the return that you end up with at the end of your investment period.
- The beginning value (BV) = how much you initially invest.
- The number of years (n) = the number of years the investment is held.
How to use the CAGR formula:
- Divide the ending value by the beginning value.
- Raise the outcome to an exponent of 1 divided by the number of years.
- Subtract 1 from the outcome.
- Multiply the outcome by 100 to turn the outcome into a percentage.
Now lets use this equation in an example to better understand how to calculate CAGR.
Example CAGR calculation
Lets use the former Investment B example to plug into the CAGR equation. So, you initially invest $1,000 in Investment B and decide that you will hold this investment for a 3-year period. This means that your beginning value is $1,000. At the end of 3 years, you see that your investment balance is $1,442.90. This means that your ending value is $1,442.90. So, lets plug this into the equation.
CAGR=(1,442.90/1000)1/31100
CAGR = 13%
As stated earlier, using the compound annual growth rate can help you compare your investment against other investment types. In addition, the CAGR can also give you an idea of future investment projections. However, understanding how to invest in stocks is also an important factor that will contribute to your decisions as an investor.
Modifying the CAGR formula
When it comes to implementing the CAGR formula, its also important to note that sometimes you will have to adjust the formula to meet your needs. An investor may not invest on the exact first day of the year and/or sell or pull funds for use on the exact last day of the year. In addition, you may also wonder how (and if) you can use the formula for future financial projections. Lets take a closer look.
Lets say you want to determine the CAGR for an investment that you made on April 1, 2019, of $2,000 with an ending balance of $2,501.46 on February 25, 2022. This means that your investment was held for the entire year from April 1, 2019, to April 1, 2020, and from April 1, 2020, to April 1, 2021. However, from April 1, 2021, to February 25, 2022, your investment was held for 331 days. Before using the CAGR equation, you must calculate the number of days to determine the value of the holding period.
April 1, 2019 – April 1, 2020 = 365 days
April 1, 2020 – April 1, 2021 = 365 days
April 1, 2021 – February 25, 2022 = 331 days
To find the value of the holding period, you will divide the total number of days, which is 1,061, by 365 (1,061/365 = 2.907). Now lets plug this into the CAGR equation.
CAGR=(2,501.46/2000)1/2.9071100
CAGR = 8%
Lets take it a step further and say that you want to find out the compound annual growth rate on an investment of $5,000 that you want to grow to $10,000. You plan to hold the investment for 5 years. Lets find out the rate at which your investment will need to grow over the 5-year period to reach your goal of $10,000.
CAGR=(10000/5000)1/51100
CAGR= 14.87%
For your ending value to reach $10,000 over a 5-year period, your CAGR will have to grow at a rate of 14.87%. However, although the CAGR is a great tool to use to determine the growth rate of historical returns, its not a definitive confirmation of future projections. Lastly, since the compound annual growth rate doesnt account for risks, doesnt show the volatility of an investment over time, and only takes into account the beginning and ending values, an investor can use a risk-adjusted CAGR. A risk-adjusted CAGR allows an investor to compare the difference between investments and account for the risks associated with the investments.
Whats a good CAGR?
There is no fixed percentage that makes a good CAGR. Business factors like size, industry, and overall risk affect it. A general rule of thumb is: Look for a CAGR of 510% for large-cap companies, 15% or more for smaller companies, and potentially even more for startup companies with room to grow.
The previous example of Investment C shows that a CAGR can be considered bad or negative if it decreases in value from your initial investment. However, an investor can measure whether a CAGR is in a strong or weak position by determining its opportunity cost and investment risks. The CAGR growth doesnt only depend on a company’s business metrics but also on the industry in which the business operates. An example of this is a company with a CAGR that may appear weak when evaluating its business metrics. However, when looking at the industry average CAGR as a whole, it may reveal that the companys individual CAGR is in good standing. Lets move on to additional limitations that come up when using the compound annual growth rate.
Limitations of CAGR
The compound annual growth rate can be a great source of information for investors when determining how well their investments have performed in the past. However, there are some limitations and risks that come with using this formula. Some of those limitations are:
- Since the CAGR formula only accounts for the beginning and ending balance of an investment, the risks and any volatility associated with the investment are not considered in the calculation. Because the CAGR presents a smooth rate, an investor wont have an in-depth understanding of how their investment performed year to year or between the investment period. This doesnt allow the investor to understand the possible risks associated with their investment.
- The CAGR formula also doesnt account for an investor adding or withdrawing funds from their investment or investment portfolio during the investment period in which they are calculating. This means that if you were to add funds to your portfolio or withdraw a sum of money, it wouldnt affect the compound annual growth rate. Since the CAGR formula only accounts for the beginning and ending value, your calculated CAGR would appear as if your investment grew or shrunk more than it actually did.
- The compound annual growth rate doesnt promise that it will stay the same. This means that the compound annual growth rate can be constant for a certain period of time and then change in the future.
- The CAGR doesnt show the full history of an investment, meaning that it doesnt show the ups and downs of an investment’s performance over a period of time.
More FAQs about CAGR
Now that we’ve covered what a CAGR is, the formula for CAGR, how to calculate it, and its limitations, lets cover a few more FAQs.
Can CAGR be negative?
The compound annual growth rate can be negative. A negative CAGR shows that an investment has decreased over a given period of time rather than increased.
How does regular growth rate compare to CAGR?
The compound annual growth rate assumes that an investment has grown at a constant rate over an investment period. However, a regular growth rate doesnt. As stated earlier, since the CAGR only inputs the beginning and ending values, the ups and downs of an investments performance over the entire investment period will not have that much effect on the CAGR. However, since the regular growth rate does account for the year-to-year performance of an investment, the ups and downs of an investment’s performance will have a significant impact on the regular growth rate.
Whats the difference between CAGR and IRR?
Now, lets define CAGR as it compares to the internal rate of return or IRR. The compound annual growth rate determines the annual return on investment over an investment period. The internal rate of return tends to be more complicated to calculate than the compound annual growth rate. While the IRR is more flexible and also determines an investment performance, an Excel sheet or financial calculator is often necessary.
The bottom line
So, what does CAGR mean for you? The compound annual growth rate is a tool that you can use as an investor to gain more understanding of the history of your investments. However, although it can help you gain insight into the annual growth of your investments over a period of time, it doesnt guarantee that the rate of growth will stay the same for future investments. Whether you are a beginner investor or well into your investment journey, understanding how stocks work can also help you understand the risks associated with investing and will help you have a better understanding of the different factors that play a role in investing. To learn more, download the Public app today!