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If you are a working professional, you may have earned promotions and saved a lot of money over the years too. Now, it is time to start thinking of investing all the extra cash.
And while you mull over your options, include this important aspect of investing while conducting your research—Compound Annual Growth Rate (CAGR).
What is CAGR?
CAGR is the average annual growth rate of an investment over a certain period, typically longer than a year, assuming compound growth.
You can also think of it as the rate of return that is needed for an investment to grow in value, from start to finish, all while reinvesting the profits at the end of every period of the investment’s tenure.
How Compound Annual Growth Rate (CAGR) works
Calculating the arithmetic average or mean of returns has its share of limitations. CAGR helps overcome these because it provides a smoothed rate of return.
It gives you a decent projection of the yields from an investment annually when compounded and can be used to assess the performance of different investments over time.
Most of us are only concerned with the absolute return of our investments when we look at their performance.
However, the time value of money is often ignored by us. This is how CAGR is different. In fact, the CAGR formula takes the time value of money into consideration.
What is the CAGR formula?
The Compound Annual Growth Rate formula is:
CAGR = [(End value/ Beginning value) ^1/n – 1] x 100
Where n is the investment period
Now, let us look at how it is calculated.
How is CAGR calculated?
From the CAGR calculation formula above, we understand that it is calculated by following these four steps.
- First, divide the investment value at the end of the investment period by the value of the same investment at the beginning of the period.
- Next, raise the subsequent result to the power of one by the number of years.
- Subtract one from this result.
- Finally, to convert the result to a percentage, multiply it by 100.
With this, you have an idea as to how to calculate the CAGR for your investments. But how can you use it in your daily life? Read on.
How is CAGR useful?
If you have been investing for a while, you know that your rate of return is never constant. It keeps varying from one year to another. However, the CAGR helps smoothen these variations out.
So, if you want to calculate how much all your investments will return over a period of years, the CAGR will assume a constant growth rate across these five years.
So, now it becomes easier for you to compare or track investment growth and performance, provided you reinvest your profits every year.
How do investors use CAGR?
Investors can use it in the following ways. Let us look at each with an example.
Compare investments
Let us say that in 2015, an investor put INR 10,000 in his bank account at a 1% rate of interest and another INR 10,000 in mutual funds.
Making a direct comparison between the two might be difficult considering the fluctuating rates of return from the stock market.
So, the investor can make use of CAGR to understand the difference in return between the two investments.
Let us assume that the investor has INR 10,150.10 in his bank account and INR 15,348.52 in his mutual fund after five years.
Now, if you apply the CAGR formula, you will find that the bank account, as promised, provided a return of 1% and the stock market gave a return of 8.95%. Naturally, you might be mistaken that the mutual fund option is more lucrative; however, the CAGR does not factor in the volatility of the stock market.
Find the present or future value of money
The CAGR formula can be used to arrive at the initial value of an investment for it to be worth something in the future.
For instance, let us say an investor needs INR 50,000 and expects a rate of return of 8%, he could find out how much he requires to save today, depending on the tenure he prefers.
Identifying the right avenue for investment
Using the example above, let us assume that the investor knows he needs INR 50,000 at the end of 18 years and has INR 10,000 ready for investing today.
Using the CAGR calculation formula, the investor will know that the rate of return for INR 10,000 to become INR 50,000 in 18 years should be 6.90%.
So, now he will look for an avenue that will give him a similar rate of return.
Advantages of CAGR
It is an effective tool that helps determine the profitability of investments over a certain period.
Short-term CAGR takes in all factors that affect the performance of your investments, and these include market parameters too.
In the long-term, it excludes all short-term fluctuations considering the possibility of your investment recovering from market variations.
As a result, it is used by several investors to understand the true potential or the strengths and weaknesses of companies.
Disadvantages of CAGR
Like we discussed already, CAGR is not the most effective measure to determine an investment’s performance. It is only a representation.
Moreover, it does not account for the fluctuations in the stock market that have a direct impact on the performance of companies.
As a result of the first limitation, CAGR cannot be used to assess risk accurately. You, as an investor, might not be able to understand the performance of a security just based on the CAGR of a company because short-term variations are not factored in.
So, along with CAGR, you would need to use other analytical tools to arrive at an investment decision.
Example of Compound Annual Growth Rate (CAGR)
We already know that the CAGR formula is (End value/ Beginning value) ^1/n -1 x 100
Let us understand this with an example. Suppose you invested INR 2,000 in Equity Linked Saving Scheme (ELSS) for three years.
The initial Net Asset Value (NAV) of your investment was INR 2,000, then it increased to INR 2,200 in the next year, and finally stood at INR 2,400 at the end of three years. So, the CAGR would be:
CAGR = (2400/2000) ^⅓ - 1 x 100 = 6.27%
The difference between absolute return and CAGR in mutual funds
By now, you would have understood what CAGR is and how it can be useful to investors. So, do you need to use the CAGR when evaluating an investment?
Well, investors use both absolute returns and the CAGR to determine the returns on investment. But there are differences between the two.
When you calculate the return as a function of the initial value and the final value and do not consider the tenure of the investment, you will arrive at the absolute returns on mutual funds.
The formula for absolute return is similar to the CAGR formula but it does not include the time.
[(End value of the investment/ Beginning value) – 1] x 100
So, if you invest INR 2,00,000 in mutual funds and sometime in the future this amount stands at INR 6,00,000, the absolute return would be:
[(6,00,000/2,00,000)-1] x 100 = 200%
The absolute return is 200% but you do not know how long it could take to arrive at this return. It could be months or years. So, you can never determine the viability of an asset by simply calculating the absolute return.
Moreover, it cannot be used to compare two investments.
On the other hand, the CAGR can indicate the growth of an investment over a period. It smoothens out the volatility of a fund and can be followed easily. It can be used to compare two investments as well.
In the previous example, we saw that the absolute return was 200%. If we were to assume that the investment matured to INR 6,00,000 in three years, we could calculate the CAGR return as [(6,00,000/2,00,000) ^⅓) – 1] x 100 = 44.22%
So, you can see that the investment grew by 44.22% every year to grow into INR 6,00,000. This was the average growth each year. On the other hand, the absolute return on this investment was 200%.
Frequently Asked Questions (FAQs) related to CAGR
How to calculate the CAGR in mutual funds?
Calculating CAGR in mutual funds is simple. You may calculate how a mutual fund has performed over a period by using the CAGR formula.
Let’s say an investment of INR 1,50,000 grew to INR 3,25,000 in three years. The CAGR of this mutual fund would be [(3,25,000/1,50,000)^1/3) – 1] x 100 = 29.40%.
Is CAGR used in banking too?
Usually, in banking, it is the annual yield from your investment that is considered and not the CAGR.
Yield is the amount of interest you can earn in a year on your investment.
Is the IRR better or CAGR?
When you are making a one-time investment, these are the same. However, the internal rate of return (IRR) is a better tool to calculate varying returns from different investments.
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