What is CAGR and Why it Matters for Your Investments
CAGR helps investors evaluate the performance of their investments and also assists in identifying new investment opportunities.
Unlike simple growth rates, CAGR accounts for compounding—meaning it includes the interest or returns added back to the invested capital over time.
Remember learning about compound interest in school? Great if you do! But even if you don’t, don’t worry—we’ve got you covered. CAGR, or Compounded Annual Growth Rate, is based on the same concept.
CAGR – Compounded Annual Growth Rate
Imagine you have ₹1 lakh to invest for the long term and want to evaluate the historical returns of different asset classes such as equities, gold, or fixed deposits. This is where CAGR, or Compounded Annual Growth Rate, becomes relevant. It helps you assess past performance and make more informed investment decisions.
What is CAGR?
CAGR (Compounded Annual Growth Rate) is a key financial metric used to measure the mean annual growth rate of an investment over a specified time period, assuming the profits are reinvested each year. It provides a smoothed annual rate of return, eliminating the impact of market volatility and short-term fluctuations.
Beyond evaluating investment returns, CAGR is also widely used in corporate analysis to assess metrics such as revenue growth, net profit growth, and Return on Equity (ROE), helping investors and stakeholders understand a company’s financial trajectory.
How Does CAGR Work?
CAGR represents the average rate at which an investment grows annually over a period exceeding one year, accounting for the effects of compounding. Unlike absolute returns or simple averages, CAGR assumes that gains are reinvested at the end of each year, which offers a more realistic picture of investment performance.
CAGR Formula and Calculation
To calculate CAGR, you need three values:
Beginning Value (Initial Investment)
Ending Value (Value at the end of the investment period)
Number of years (n)
CAGR Formula:
CAGR = [(Ending Value / Beginning Value)1/n] – 1
Example:
If you invested ₹1,00,000 and it grows to ₹1,50,000 in 5 years, then:
CAGR = [(1,50,000 / 1,00,000)1/5] – 1
CAGR = 0.0845 or 8.45%
So, the compounded annual growth rate of your investment is 8.45%.
What is CAGR in Stocks?
In the stock market, prices fluctuate daily due to market sentiment, economic data, earnings announcements, and geopolitical events. CAGR helps smooth out these fluctuations, offering a clearer picture of a stock or portfolio’s performance over time. Investors can also compare their portfolio CAGR with benchmark indices such as NIFTY 50 or NIFTY 500 to assess relative performance.
Applications of CAGR
CAGR is a valuable tool for long-term investors and analysts. Its main uses include:
Portfolio Analysis: Track the performance of individual stocks or mutual funds within your portfolio.
Stock Selection: Identify and remove underperforming stocks and replace them with better-performing ones.
Business Analysis: Companies use CAGR to measure the long-term trends in revenue, profits, and other financial metrics to guide strategic decisions.
Advantages of CAGR
Whether you’re a beginner or an experienced investor, CAGR offers several benefits:
Cross-Asset Comparison: Use CAGR to compare returns across different asset classes—such as equities, gold, fixed deposits, or cryptocurrencies.
Informed Company Evaluation: When evaluating companies within the same sector, CAGR enables you to compare growth metrics like revenue and net income over the same period.
Long-Term Focus: It smooths out short-term market volatility, making it ideal for evaluating long-term investments.
Limitations of CAGR
Despite its usefulness, CAGR has a few important limitations:
Historical Focus: CAGR is based on past performance, which does not guarantee future results.
Ignores Volatility: It assumes consistent growth and doesn’t reflect the ups and downs of actual returns—especially important in volatile markets like equities.
Period Sensitivity: CAGR results can vary significantly depending on the time frame chosen. Mutual funds or companies may highlight convenient periods that show favorable results, potentially misleading investors.
Final Thoughts
CAGR is a powerful metric for evaluating the long-term growth of investments or businesses, offering a simplified yet meaningful view of returns. While it shouldn’t be the only tool you rely on—especially due to its limitations—it is an essential part of every investor’s and analyst’s toolkit when assessing performance over time.
FAQs on CAGR
The formula for CAGR is:
CAGR = (Ending Value / Beginning Value)1/n – 1
Where n is the number of years.
Yes, CAGR can be negative. A negative CAGR indicates that the final value of the investment is lower than the initial value, reflecting a decline over the period.
CAGR is best suited for long-term investments, ideally over 3 years. For shorter durations, it may not accurately reflect performance due to market fluctuations.
CAGR is based on historical performance. While it can indicate potential trends, it cannot reliably predict future results, as past performance does not guarantee future returns.
Absolute return is useful for short-term evaluations. CAGR is better for comparing long-term investments, especially those held over different time periods, as it reflects compounded growth.
Still have questions? If you need more information or have specific questions, feel free to reach out. We’re happy to help you find the answers you’re looking for.