What Is Compound Annual Growth Rate (CAGR)? Meaning, Calculation and Formula
3 May, 2025
Synopsis
The CAGR calculates the average return on an investment over a period of time.
CAGR essentially factors in the element of compounding to arrive at the returns of investment.
CAGR is useful in the analysis of investment by comparing past performance of various investment instruments based on the calculation of annualized returns.
Investment growth can be unpredictable, and profits can change on an annual basis. A standard method of measurement needs to be used to understand the performance of investments over a period of time and this is where CAGR comes in.
This article looks into what is CAGR meaning, how it works, and why it is so important to investors.
What Is the Compound Annual Growth Rate (CAGR) and How it works?
The CAGR full form is Compound annual growth rate (CAGR), which is a significant financial indicator that measures the average return of an investment over a period of time assuming profits are being reinvested. Unlike the basic average return, CAGR considers the effect of compounding, making it a suitable measure of consistent growth. It is often applied in assessing stock market investments, mutual funds, and businesses.
Assume an investment growing from ₹10,000 to ₹20,000 in five years. The overall gain is 100%, but CAGR calculates the consistent annual growth rate. Using the formula, the CAGR would be around 14.87%, meaning if the investment grew steadily each year, it would increase by this percentage annually to reach ₹20,000.
CAGR works by calculating the average annual growth rate of an investment while factoring in the impact of compounding. Unlike absolute returns, which only show the total increase over a specific period, CAGR expresses growth as a steady annual rate. This allows investors to understand how well an investment has performed over time, even if actual returns varied from year to year.
For assets held for three to seven years, CAGR is particularly useful because it presents a more accurate picture of growth patterns. It offers a complete comparison of different investment options and smooths out market fluctuations. CAGR is a measure employed by companies, financial experts, and investors to gauge market growth, revenues, and mutual fund and stock performance.
Example:
Suppose an investor puts ₹50,000 into a mutual fund, and after five years, the investment grows to ₹1,00,000. The total return is 100%, but this does not reveal the year-by-year growth.
How to Calculate CAGR
The formula for CAGR is:
CAGR = (Ending Value / Beginning Value)^(1 / Number of Years) - 1
To calculate CAGR:
Identify the initial investment value.
Determine the investment value at the end of the period.
Find the total duration of the investment in years.
Apply these values in the CAGR formula.
For example, if you invested ₹10,000 in a mutual fund, and after five years, its value grew to ₹15,000, the CAGR calculation would be:
CAGR = (15,000 / 10,000)^(1/5) – 1
= 8.45%
This means that the investment grew at an average annual rate of 8.45% over five years.
What is CAGR in Stocks?
In the stock market, CAGR tells investors the year-to-year return of a stock or portfolio over a given number of years. Stock prices fluctuate on the basis of market forces, economic conditions, and corporate performance. By using CAGR, investors can measure how well a stock has done over a few years, considering these fluctuations. It makes it easy to compare stocks and select those with consistent long-term growth.
Uses of CAGR
1. Investment Analysis
Investors apply CAGR to analyse mutual funds, portfolios, and stocks. Through the calculation of the annualised return, they can compare investments and determine past performance, making it easier to make financial decisions.
2. Business Growth Measurement
Firms measure their sales, revenue, and profit expansion through CAGR. It allows companies to identify their long-run trend of performance and establish attainable financial objectives. CAGR is especially suited to multi-year growth analysis and remains unaffected by short-run swings.
3. Financial Forecasting
CAGR facilitates forecasting future growth in investments and aids in long-term financial planning. Through analysis of past trends, companies and investors can estimate likely returns and make strategic decisions regarding where to invest capital and grow.
4. Performance Benchmarking
CAGR enables investors to benchmark the performance of various assets across comparable periods. Whether measuring stocks, mutual funds, or revenues of businesses, CAGR gives a common basis for measuring returns, which facilitates comparison of the top-performing investments.
Limitations of CAGR
While CAGR is a powerful metric, it has some limitations:
Ignores Market Volatility: CAGR assumes steady growth, which may not reflect real-world market fluctuations.
Does Not Show Yearly Variations: Since CAGR smooths returns, it does not highlight significant gains or losses in specific years.
Not Ideal for Short-Term Analysis: CAGR is best suited for long-term investments and may not accurately reflect short-term performance.
CAGR is a crucial tool for investors and companies to analyse long-term growth. CAGR offers a simplified yet accurate method of gauging investment performance with compounding effects in mind. But investors must utilise CAGR in combination with other financial indicators in order to make informed decisions.
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FAQs
1. How is CAGR different from absolute returns?
CAGR considers the growth per annum with compounding, while absolute returns indicate mere cumulative growth over time without considering the effect of time.
2. Can CAGR be negative?
Yes, if an investment decreases in value over time, the CAGR will be negative and will indicate loss rather than growth.
3. Can CAGR be used for short-term investments?
CAGR is more suitable for longer investments, typically three or more years, as short-term fluctuations skew its accuracy.
4. Will CAGR predict future returns?
CAGR reflects the past but does not guarantee future returns, as market forces change.
5. Is CAGR useful for comparing different investment options?
Yes, CAGR makes it possible to compare investments for a given time period using a uniform factor, allowing the investor to make an informed choice.
*Disclaimer: Terms and conditions apply. The information provided in this article is generic in nature and for informational purposes only. It is not an investment recommendation. Investments are subject to market risks and other risks.
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