What Is the Compound Annual Growth Rate (CAGR)?

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What Is the Compound Annual Growth Rate (CAGR)?

Let me explain what the compound annual growth rate, or CAGR, really is. It's the rate of return your investment would need each year to grow from its starting balance to its ending balance over a specific period. This assumes you're reinvesting any profits at the end of each period throughout the investment's life.

Key Takeaways

You should know that CAGR is one of the most precise ways to calculate and assess returns for assets that can increase or decrease in value over time. It gives you a smoothed rate of return. As an investor, you can use it to compare how one stock performed against others in its group or against a market index. This makes CAGR effective for evaluating investment performance over time or against benchmarks. However, remember it doesn't account for investment risk.

How to Calculate Compound Annual Growth Rate (CAGR)

Here's the formula you need: CAGR = ((EV / BV)^(1/n) - 1) × 100, where EV is the ending value, BV is the beginning value, and n is the number of years. To compute it, divide the ending value by the beginning value, raise that to the power of one divided by the number of years, subtract one, and multiply by 100 for the percentage. This gives you an annualized return rate that's great for comparing investments.

What the CAGR Can Tell You

CAGR isn't your actual return rate; it's more of a representative number. It shows the rate at which your investment would have grown if it increased at the same pace every year with profits reinvested annually. For you as a stock market investor, this is useful for comparing different stocks' performances. Keep in mind, it doesn't factor in the discount rate, which matters for present value of future returns. In practice, such steady performance is rare, but CAGR smooths things out for easier understanding and comparison.

Example of How to Use CAGR

Suppose you invested $10,000 and it grew to $13,000 in the first year (30%), then to $14,000 in the second (7.69%), and $19,000 in the third (35.71%). The year-to-year rates vary, but CAGR smooths it to 23.86% over three years. You calculate it as (($19,000 / $10,000)^(1/3) - 1) × 100. This helps you compare options or forecast future values, like smoothing returns for high-yield bonds versus stocks.

Additional CAGR Uses

You can use CAGR to find the average growth of a single investment, smoothing out volatile year-to-year changes. It's also good for comparing different investments, like a savings account at 1% versus a stock fund ending at 8.95% CAGR over five years. Additionally, track business performance, such as market share or customer satisfaction, to spot strengths and weaknesses. Comparing across companies reveals competitive edges.

How Investors Use the CAGR

You can manipulate the CAGR formula to find present or future values or hurdle rates. For instance, if you need $50,000 in 18 years from $15,000 today, the required CAGR is 6.90%. This is essentially a rearranged present value equation.

What Is a Good CAGR?

A good CAGR depends on context, your opportunity cost, and risk. Higher is generally better, but compare it to industry averages—if your 25% beats a 10-15% average, it's strong.

Modifying the CAGR Formula

Investments aren't always held for full years. For a $10,000 investment from June 2013 sold for $16,897.14 in September 2018 (5.271 years), the CAGR is 10.46%. Adjust the exponent for the fractional period.

Smooth Rate of Growth Limitation

CAGR's main limit is it assumes steady growth, ignoring volatility. It also doesn't handle added or withdrawn funds, which can inflate the rate inaccurately.

Other CAGR Limitations

Past steady growth doesn't guarantee the future, especially over short periods. It can misrepresent by focusing on select periods, like a 42.01% three-year CAGR hiding a 4.73% five-year one.

CAGR vs. IRR

CAGR is simple for hand calculation, while IRR is more flexible for complex cash flows, often needing tools like Excel.

CAGR FAQs

What Is an Example of Compound Annual Growth Rate (CAGR)? It's used to find growth like revenue from $3 million to $30 million over 10 years at about 25.89%.
What Is the Difference Between the CAGR and a Growth Rate? CAGR compounds annually, smoothing volatility, unlike simple growth rates.
Can the CAGR Be Negative? Yes, indicating losses.
What Is Risk-Adjusted CAGR? Multiply CAGR by (1 - standard deviation) to adjust for risk.

The Bottom Line

CAGR gives you a clear view of investment growth by smoothing returns, aiding comparisons and predictions. But it overlooks volatility and risk, so use it with other metrics for informed decisions.

What Is the Compound Annual Growth Rate (CAGR)?

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