The full form of CAGR is the compound annual growth rate. The yearly rate of growth in the value of an investment or financial indicator, such as revenue, over a given time period is known as CAGR. The CAGR essentially “smooths” the growth rate by giving the growth rate as though the changes happened uniformly and at the same rate across each period.
The following table lists the three inputs required for the formula to calculate CAGR.
- Initial Value Final Value
- Quantity of Periods (n)
- To convert the rate to a percentage, use the CAGR calculation, which requires dividing the ending value by the beginning value, multiplying that result by the inverse number of periods (1 / # of periods), and finally subtracting one.
Benefits and Drawbacks of CAGR
The main advantage of CAGR is that it may be used as a rapid and accurate growth indicator for anything whose value increases (or decreases). The CAGR can also be helpful as a sanity check because it helps verify whether the estimates are in line with industry averages and/or historical growth.
Let’s say a firm is predicted to expand at a CAGR of 20%, but its nearest competitors are predicted to develop at a rate of about 5% while the industry as a whole is predicted to grow at a rate of 3% during the same time periods.
If this were the case, the company’s growth projections would probably benefit from some revisions, or at the very least, a closer examination of whether the figures are accurate.
Annualized growth measurements make it easier to compare the CAGRs over time between two businesses or investments since they eliminate the swings that can occur with year-over-year growth rates.
The primary flaw with the CAGR is that it ignores the volatility related to the underlying asset. As a result, the growth statistic is susceptible to misunderstandings because the real growth rate experienced year over year may differ. For instance, a company’s revenue growth may be disproportionate, with favourable growth front-ended in the earlier stages before eventually slowing down or even flattening.
Without further investigation, the CAGR can deceive by falsely portraying the company’s ability for steady, positive growth.
Steps in CAGR Calculation
Let’s say a business had $20 million in revenue at the end of the current quarter (Year 0).
The company’s revenue is anticipated to reach $32.5 million in five years (Year 5).
Note that Year 0 is not included in the calculation of the total number of periods because we are only considering the periods during which the revenue is compounding; in this case, Year 5 minus Year 0 is 5 Years. The beginning value of $20 million is divided by the ending value of $32.5 million in the first portion of the formula.
The amount must then be raised to the power of 1 and divided by the five periods to make it annual.
Finally, we arrive at 10.2% as the CAGR as shown below after deducting 1 from the return value.
Using the formula – Compound Annual Growth Rate (CAGR) is calculated as ($32.5 million / $20.0 million)(1 / 5 periods) – 1 CAGR, which is equal to 10.2 percent.
Calculating CAGR and using mutual funds
Mutual fund investors can benefit greatly from the CAGR calculator. You can use this calculator to determine how well your fund is doing and to make the required investment decisions. The following are some uses for a CAGR calculator:
Improved investment choices – The CAGR calculation is a very helpful tool to use each year as you assess your investing choices. The CAGR calculation, for instance, will show you the average annual return you have received over the last five years if you bought an equity mutual fund five years ago. This might assist you in determining whether or not the fund’s returns meet your expectations. If the fund isn’t doing well, you might want to think twice about making that investment in the future.
Compare returns between various funds and benchmarks – The CAGR calculation may also be used to compare the returns you receive from one fund to those of other funds with a similar investment strategy. This can aid in your understanding of the mutual fund’s performance in comparison to that of its competitors. For added clarity, you can also evaluate against the benchmark indices.
CAGR is a very helpful formula for estimating an investment’s growth rate. It can be used to gauge prospective returns on your assets or assess historical profits. But keep in mind that CAGR is effective for lump-sum investing. Systematic Investment Plans (SIPs) do not account for recurring investments; instead, the calculation simply takes into account the initial and end values. The CAGR calculator is an extremely helpful tool that can assist you in analysing your investments overall.