- CAGR stands for compound annual growth rate, and it is a measure of an investment’s average past performance over a long period of time.
- CAGR doesn’t predict how an investment will perform in the future.
- CAGR has its limitations and doesn’t necessarily reflect an investment’s actual performance.
By their very nature, markets fluctuate constantly, making it difficult to know which investments are worth sinking your money into. While there’s no way to reliably predict what’s going to happen in any given market, there are some indicators that can give you an idea of what opportunities might be worth exploring.
Compounded annual growth rate (CAGR) is one such measure. Here is a closer look at what CAGR is and what it means in terms of investments.
What is compound annual growth rate (CAGR)?
CAGR is a formula that calculates how the value of an investment has changed over the course of a specific time period, assuming all earnings have been reinvested and no deductions have been made. This calculation allows investors to look at how much an investment has gained or lost over one or more years as a way to determine overall performance. It’s a useful tool for comparing multiple investments to see what might be worth buying into, whether it’s securities, property, business, or anything else of value.
How CAGR works?
CAGR is calculated by looking at the initial and final values of an asset over a period of time in order to evaluate performance or growth in value. This formula is relatively simple and assumes that any value earned or revenue — through interest or dividends in the case of financial securities — has been reinvested and compounded into the investment.
The CAGR measure can be used in any industry, However, it can be used in the investment world to complement other widely used measures, such as time-weighted return. This is because some assets are not publicly traded and it’s harder to know their value at a specific time every month/year to evaluate growth or rate of return.
CAGR is useful when applied to assets that don’t have publicly available data to determine performance, such as property or physical assets.
This is because having an initial value for a physical asset and a final value for the same asset, regardless of the time frame, allows you to calculate it. “There is no need to constantly know the value of this asset to get to CAGR.
CAGR formula
To calculate CAGR, use the following formula:
Divide the final value of an investment by its starting value.
Apply the exponent of 1/N to that quotient. The value of N will be the timeframe you're evaluating, such as a number of years.
Finally, subtract 1 from the value you get from applying the exponent. Let’s see how this works when you put it all together. To keep things simple, we are going to determine the CAGR for an investment that has grown from $100 to $108 in value over 5 years. Your formula would look like this when you plug in all of the values:
CAGR = (108/100)/^⅕ -1 = .015511 or 1.5511%
This tells us that on average, the investment gained 1.5511% in value each year during the selected five-year period. Some years may have seen more growth and others less. But it smooths out to this rate when you look at the timeframe as a whole.
How investors use CAGR?
One of the most common reasons investors use CAGR is to compare investments. Though you’re not seeing the actual gains and losses from year to year, CAGR shows you how an investment has historically performed. You can use this information to learn about one or more investments, see how they measure up to one another, and make informed decisions about where you want to put your money.
You can also use CAGR to track business performance as a result of measures a company takes, such as policy changes or new products introduced to market. It can also give you an idea of a business’ strengths and weaknesses. For example, a CAGR that shows a steady decline over a number of years might indicate that internal or external issues are impacting profitability and the business is struggling to overcome them.
How investors use CAGR?
One of the most common reasons investors use CAGR is to compare investments. Though you’re not seeing the actual gains and losses from year to year, CAGR shows you how an investment has historically performed. You can use this information to learn about one or more investments, see how they measure up to one another, and make informed decisions about where you want to put your money.
You can also use CAGR to track business performance as a result of measures a company takes, such as policy changes or new products introduced to market. It can also give you an idea of a business’ strengths and weaknesses. For example, a CAGR that shows a steady decline over a number of years might indicate that internal or external issues are impacting profitability and the business is struggling to overcome them.
How investors use CAGR?
One of the most common reasons investors use CAGR is to compare investments. Though you’re not seeing the actual gains and losses from year to year, CAGR shows you how an investment has historically performed. You can use this information to learn about one or more investments, see how they measure up to one another, and make informed decisions about where you want to put your money.
You can also use CAGR to track business performance as a result of measures a company takes, such as policy changes or new products introduced to market. It can also give you an idea of a business’ strengths and weaknesses. For example, a CAGR that shows a steady decline over a number of years might indicate that internal or external issues are impacting profitability and the business is struggling to overcome them.