In terms of investing and business, the compound annual growth rate is the geometric progression ratio. This ratio provides a constant rate of return over time. The higher the CAGR, the higher the investment's growth potential.
The compound annual growth rate has become a popular term in the financial world, especially in the stock market. But what exactly is it?
Let's explore the concept. The CAGR is calculated by multiplying the rate by the number of years it takes for it to reach its highest potential. Keep reading to know more.
Did You know?
If your investor skills make you search for stable returns by investing in huge turnover organisations from the financial market, then 8% can be an ideal CAGR percentage for you. However, if you’re ready to invest in a medium or high-risk organisation, you should have a minimum of 15-25% is an ideal percentage for them.
Also Read: What Is the Difference Between Savings and Investment?
What Is CAGR and How Can it Help You?
If we talk about CAGR meaning, it’s a mathematical calculation of the rate at which a company's revenue would grow by a certain amount each year. It smooths out lumpy growth by assuming that the company's sales increase on average every year.
If the company's CAGR is 5%, then it would gain 58% over three years. However, the CAGR is not that simple. For investors and CEOs, the CAGR is useful for comparing the growth rates of two investments.
Advantage 1
When investing, it is essential to understand the difference between the CAGR and the internal rate of return. While the CAGR is a more flexible measure of investment performance, an internal rate of return provides the most accurate picture of an investment's growth over time.
This rate is most helpful when investing in more complex investments and involves many different cash inflows and outflows. A financial calculator, Excel, or portfolio accounting systems are useful tools for backwards-looking into the internal rate of return.
Advantage 2
A CAGR can be useful for quick growth analysis and to confirm that a company's projections are in line with the historical growth of the industry. But it can also be misleading in that it misrepresents consistent positive growth.
For example, if a company's CAGR is 30%, it may only have a marginal impact on the growth rate of a particular industry. So the CAGR should not be used as a sole metric.
Advantage 3
The CAGR is a mathematical formula that takes the time value of money into account when calculating an investment's growth. Investors use this rate to compare the real returns of an investment with savings accounts or bonds.
And they can also use it to forecast the value of an investment by using historical data. This formula has helped investors calculate the CAGR of their investments. And it's the same for stocks and bonds and can be applied to a variety of personal finance scenarios.
Beware
CAGR can sometimes produce inaccurate results for volatile investments. And it's best to consider the risk-reward ratio alongside the CAGR when comparing investment options. And, of course, as with any other financial tool, you should also take the time to consider the risk and return of a particular investment before investing.
How to Calculate Compound Annual Growth Rate (CAGR)?
In terms of investing and business, the compound annual development rate is the geometric progression ratio. This ratio provides a constant rate of return over time. The higher the CAGR, the higher the investment's growth potential. The compound annual growth rate has become a popular term in the financial world, especially in the stock market.
It's vital to understand the compound annual growth rate formula:
- Divide the investment value at the period's end by the value it has at the period's beginning.
- Multiply the result by the exponent of a single divided by the year's number.
- Subtract 1 from the result of the subsequent.
- Multiply by a hundred, and you'll get the answer in percentage.
This calculation will give you a smooth rate, but it won't help you identify possible risks. That's why the formula is so popular with investors. But don't be fooled by this simple formula.
You can use a CAGR calculator to make this calculation, or you can use the XIRR function of Microsoft Excel to compute it. Just enter the formula (V2/V1)/t1 into a spreadsheet cell to calculate the CAGR.
Also Read: Guide on Return on Investment (ROI) - Learn How to Calculate ROI with ROI Formula
Example of How to Use CAGR
The CAGR formula is a rearranged version of the present value equation. You can use this formula to calculate hurdle rates of return. Suppose you have ₹15,000 to invest today and need ₹50,000 for your child's college education in 18 years. You expect to make 8% per year on that investment. The CAGR formula would be useful in such scenarios. However, this method is not for everyone. It can be confusing.
Here is a practical example:
Suppose we want to calculate a company's revenue.
At the current period's end, the company has made ₹10 lacs in revenue – and we're expecting this figure to grow by the growth rates each year mentioned below:
- Year 0 → First Year 1: 10.0%
- First Year → Second Year 2: 8.5%
- Second Year → Third Year: 8.0%
- Third Year → Fourth Year: 6.5%
- Fourth Year → Fifth Year: 5.0%
By the end of the Fourth Year, the company's revenue hit ₹14.4 lacs. Now, we'll input the below-mentioned assumptions into our CAGR formula:
- Beginning Value = ₹10 lacs
- Ending Value: ₹14.4 lacs
- Number of Periods: 5 Years
This CAGR formula divides ₹14.4 lacs (the ending value) by ₹10 lacs (the beginning value) and raises it to 1/5 (the number of periods).
In the next step, we subtract by 1 to find the 7.6% as the implied CAGR.
- CAGR = (₹14.4 lacs / ₹10 lacs)^(1 / 5 Periods) – 1
- CAGR = 7.6%
Additional CAGR Uses
1. Comparing Investments
The CAGR can be used to compare the performance of different investments over time. To make the calculations more useful, you must be aware of the time value of money. While calculating your CAGR, always remember that you should consider the time value of money and invest in a portfolio that shows a stable growth rate. Likewise, your investment should not be subject to high volatility. In addition, it should be free from volatility. With CAGR, you'll have an idea of how much your investments are worth, even years after you've made them.
2. Track Performance
While the CAGR formula does not provide an exact ROI, it does help you compare different investment options and compare their performance. So if you are investing in a company that consistently produces high returns, consider using the CAGR to compare the performance of its competitors.
3. Detect Weaknesses and Strengths
Comparing the business CAGRs operations between similar businesses will allow you to identify the strengths and weaknesses of competitors. For instance, Big-Sale's satisfaction CAGR may not appear as low when compared to SuperFast Cable's satisfaction CAGR of -6.31% during the same time.
Also, you can learn about the basis of accounting to better understand the formulas and calculations of payments.
Advantages of CAGR
Here are a few benefits of making use of CAGR to calculate long-term average growth.
- It's easy to grasp and use. All you need to do is enter the value of the initial investment, the final price and the desired time frame for investment. The calculation can be made simpler by using online calculators, scientific calculators, or spreadsheets in Excel.
- It lets investors evaluate the return on investment in a range of scenarios. For instance, you can imagine how much your initial investment will grow in a given time with different CAGR scenarios. This can be useful for financial planning.
- For a longer time, absolute returns may be confusing. In these instances, the CAGR can assist you in evaluating other similar instruments to see whether you're doing superiorly to other investors. If, for instance, you bought parts in the Equity fund before time and their value increased significantly, you can use the CAGR to gain an estimate on the annualised average gains you earned.
- You may also use the calculator of compound annual rate to assess the performance of the stock within the peer group and also against the index to determine whether the fund manager is performing much better than benchmarks for the market.
- CAGR is an indicator of capital return and is the most important factor when compared with the cost of funds. If, for instance, your cost of funds is 9.9%, then you should consider an investment that has CAGRs of greater than 120% to create an investment spread.
Conclusion
CAGR can be an efficient way to determine the rate of growth that an investment will yield. It is a great way to assess the returns of past investments or forecast the future return of your investments. But, keep in mind that CAGR can be used to evaluate lump sum investments.
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