Updated Feb 20, 2022

What is Compound Annual Growth Rate (CAGR)?

What is CAGR?

Introduction

CAGR stands for Compound Annual Growth Rate, which is the annual growth of the investments made by a person during a particular duration. It can also be defined as the rate of return necessary for the investment’s growth. It is different from the absolute return as absolute return does not include time while calculating the investment returns. Therefore, CAGR is considered comparatively better.

Uses of CAGR

When taken in absolute terms, the returns could be ambiguous or deceptive, for the absolute returns do not indicate the amount by which the investment has grown per year. The CAGR then comes into the picture and informs the investor about the compounded returns earned yearly regardless of the investor’s annual performance in terms of funds. CAGR offers a representation of the growth of investment per year at a steady rate. In simple terms, it is the calculator for getting the average returns on the investment annually. Here are a few uses of CAGR:

Average Growth Calculation of Single Investment

The CAGR can also help indicate the average growth of any single investment. However, there are chances that market volatility may cause the year-to-year investment growth to seem uneven and unreliable or unpredictable.

Comparing Investments

CAGR assists in comparing investments of numerous kinds. It could be used for comparing the investment in a stock mutual fund and the investment in a savings account and other such investments to know which would offer better returns.

Performance Tracker

Multiple companies might need to be tracked or studied in terms of their performance of the business measures together or simultaneously. These performances could be tracked with the help of CAGR. Instance- the CAGR of customer satisfaction of one company (company X) maybe 0.49%, while company X’s market share CAGR might be 1.58%. Such comparisons indicate the strengths and weaknesses of the company.

Advantages of CAGR

CAGR is considered quite an advantageous way of calculating returns for the following reasons:

• CAGR is considered, for the most part, to be the most accurate method of calculating historical returns, which is seen as one of its major advantages.
• CAGR is also seen as advantageous in terms of performance assessment. CAGR makes it possible to compare a number of different investment performances to get an overall relative performance chart of the investments.
• CAGR, as mentioned, calculates the returns of the property yearly, but it also proves to be helpful while trying to estimate the returns from the properties in the future. It helps in projecting potential returns of the investments.

Limitations of CAGR

• CAGR has limitations, among which the first one refers to a smooth growth rate calculation with its help during a specific duration; the volatility is not taken into account. Therefore, the growth is believed to be stable at that specific time, which is not true as the returns are bound to be irregular on the investments.
• Another limitation of CAGR is that it very comfortably ignores the funds that are either added or withdrawn from the portfolio while the growth of the investments is being calculated. For Instance- suppose an individual has an investment portfolio for three years. And the Individual adds funds up to a three-year duration in the investment portfolio. Here, the CAGR is bound to be inflated as it considers the initial and the concluding balances, which easily ignores the added on funds. Thus the growth rate then comes out as incorrect.
• CAGR limitation related to the growth rate for the future is something investors should know about. It isn’t possible or feasible for any company to continue with the same growth rate as in the past because the rate may be different in the future.
• It has been observed that CAGR isn’t capable of taking the risk factor of investment into account while calculating the growth rate.

Conclusion

Here, we explored all about CAGR and its role in determining growth rate. Moreover, whether the investments have been profitable or not in a given time could be known through the compound annual growth rate as it shows the returns on investment. However, the CAGR is productive and suitable for calculating when investments are taken into round sum amount.