What is CAGR? All you need to know!
Updated on 23 Mar 2020
An investment jargon that sounds like a tongue twister, CAGR is important when calculating your return on investment. Learn all about it here.
What is CAGR?
CAGR stands for Compound Annual Growth Rate. It is the rate of return that you would likely to get to reach an ending point from a beginning point, assuming that the investments have been compounding over a time period. The assumption is basically regarding the fact that the profits were reinvested at the end of each year of the investment’s life span.
Rate of return can be explained as a net gain or loss, represented in percentages, with respect to the investment’s initial cost. Since CAGR uses an annual time period, it is important to make sure that you are not only looking at an advertised CAGR before making an investment. The CAGR that you get is not an annual constant and should not be considered as such.
CAGR Formula and How to calculate the CAGR
CAGR = (EV / BV)1 / n – 1
where EV= Investment’s Ending Value
BV = Investment’s Beginning Value
n = Number of periods/Investment period (months or years)
One thing you need to note here is that you are supposed to count only the number of years that have been completed. For example, if you are taking a value of $100 at the end of the year 2014 as your Beginning Value (BV) for a time span of the next four years till 2018 then the number of periods/investment period (n) has to be 4 and not 5. Since you are not taking the fluctuations seen in the first year, you are not supposed to count that. This is a common mistake that most people make.
If you think that the Average Annual Return is a good enough method then we shall help you break that bubble once and for all. Take an example of an investment made of $10,000. You are left with $7,500 at the end of the first year, which has a return of -25%.
You then see an increase of 33% in your amount, making your average return % of both years to be 4%. This is misleading as it gives you a false sense of progress. The reality is that you have actually not made any progress in the two years as the principal amount is still at $10,000. The actual return % is 0!
Since the Average Annual Return method does not count the effects of compounding, it is important to make sure that you are not overestimating your growth in any way. This is where CAGR trumps this method by giving you an accurate rate at which your investment has seen growth with respect to compounded investment.
Are IRR and CAGR the same?
Since IRR and CAGR both give us a measure of return of the investments, a novice investor might think that they are similar to each other. However, one major difference between them is that the Compound Annual Growth Rate (CAGR) takes only one initial investment i.e. cash outflow and only one ending point i.e. cash inflow.
In contrast, IRR can have multiple initial and ending points. It is due to this versatility that IRR is chosen for things like identifying if the proposed projects can generate higher returns than the existing investments or something like identifying the acquisition targets of a company that provides the best returns.
How is CAGR better than absolute return?
CAGR is much better than absolute return in every sense because it takes the quotient of time into consideration. Absolute return(total return) is a very simple and basic formula that just tells you about the return% with respect to the beginning and the ending value.
The formula for absolute return(total return) is – Absolute Return % = ((ending value – beginning value) / beginning value) x 100). For example, if you invested $100 over time it turned into $200 to give you a 100% absolute return. Howsoever good it may sound, you have no idea about the time taken to get this return. CAGR helps you measure your growth on an annual basis and is more accurate in terms of getting an understanding of how your investment is working.
Pros and Cons of CAGR
CAGR is much superior to other formulas like an average return or absolute return, as it focuses on returns calculated by a compounding method.
CAGR is not that good for the long run as it does not show you the volatility involved in your investments, especially stocks. CAGR has the capacity to hide the interim instability and instead show you an overall steady growth.
Another loophole in CAGR is that it can be subjected to manipulation. One can choose a time period arbitrarily and end up having figures that are misleading and does not give you an accurate picture. This is a common practice to hide the performance of a negative year, which was commonly seen in 2008.
CAGR helps you identify your growth or return%, assuming that your investment compounds over time. It does help you compare various investments with similar volatility but cannot be trusted fully for calculating returns on all your investments, especially because of the fact that it works on assumptions.
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