What is CAGR? (Compound Annual Growth Rate)

Investing is all about understanding how your money grows over time. One of the most reliable metrics to evaluate this growth is the Compound Annual Growth Rate (CAGR). Whether you're assessing mutual funds, stocks, or other financial instruments, CAGR helps investors understand the average annual growth rate over a specific period. By smoothing out year-to-year volatility, CAGR provides a clear picture of long-term performance. Let's break down its definition, formula, features, and limitations.

Definition of compound annual growth rate

The compound annual growth rate (CAGR) is a widely used financial metric that shows the mean annual growth rate of an investment over a specific period of time, assuming the investment has grown steadily at the same rate each year. Unlike simple averages, CAGR reflects the compounded growth, providing a clearer picture of how investments have performed over time.

In simple terms, CAGR tells you how much an investment would have grown each year if it had increased at the same rate annually. This makes it a powerful tool for assessing investment performance, comparing mutual funds, or tracking business growth.

Formula for CAGR

The formula for calculating CAGR is:

CAGR = [(Ending Value / Beginning Value) ^ (1 / Number of Years)] - 1

Explanation:

• Ending Value: The value of the investment at the end of the period.
• Beginning Value: The value of the investment at the start of the period.
• Number of Years: The total duration for which the investment has been held.

Example:

Suppose you invested ₹1,00,000 in a mutual fund, and after 5 years, its value grows to ₹1,80,000. Using the CAGR formula:

CAGR = [(1,80,000 / 1,00,000) ^ (1/5)] - 1
CAGR = [(1.8) ^ 0.2] - 1
CAGR = 1.125 - 1 = 0.125
CAGR = 12.5%

This means your investment grew at an average rate of 12.5% per year over the 5-year period.

Key features of CAGR

1. Consistency in Growth Analysis

CAGR smooths out fluctuations in annual returns and presents a consistent growth rate. This is particularly useful when comparing investments with uneven growth patterns.

2. Effective for Long-Term Analysis

CAGR is ideal for analysing investments over multiple years. It helps investors evaluate the sustainability of a fund’s performance over time.

3. Comparison Tool

Investors use CAGR to compare different investment options, such as mutual funds, stocks, or bonds. Since CAGR represents a steady growth rate, it offers a fair comparison.

4. Business Growth Indicator

In addition to financial markets, CAGR is widely used to measure business performance, revenue growth, or customer base expansion.

5. Assumes Steady Growth

CAGR assumes that investments grow consistently over the period. While real-world returns may vary, CAGR offers a simplified view for better understanding.

Limitations of CAGR

1. Ignores Market Volatility

CAGR does not account for the ups and downs an investment might experience during the period. While it shows a smooth growth path, actual returns can be highly volatile.

2. No Reflection of Interim Gains or Losses

CAGR only considers the beginning and ending values. Any intermediate fluctuations are ignored, which can misrepresent the investment's true risk profile.

3. Not Suitable for Short-Term Analysis

Since CAGR averages returns over multiple years, it may not accurately reflect short-term performance trends.

4. Excludes External Factors

CAGR does not factor in dividends, fees, taxes, or other expenses that may affect investment returns.

Example Limitation:

Suppose an investment rose by 30% in the first year, dropped by 10% in the second year, and then climbed by 20% in the third year. CAGR will reflect a steady growth rate, masking the actual fluctuations.

Conclusion

CAGR is a powerful metric for evaluating investment performance, particularly for long-term investments. It simplifies complex growth patterns into a single, understandable figure, making it easier to compare different funds, stocks, or business performances. However, while CAGR provides valuable insights, it should always be used alongside other metrics like standard deviation, Sharpe ratio, and absolute returns for a comprehensive investment analysis. By understanding its strengths and limitations, investors can use CAGR effectively to make informed financial decisions.