Compound Annual Growth Rate (CAGR)

The Compound Annual Growth Rate (CAGR) is a metric used to measure the mean annual growth rate of an investment or a financial metric over a specified period of time, assuming the investment grows at a consistent rate compounded annually. It represents the rate at which an investment would have grown if it had grown at the same rate every year.

CAGR is often used to compare the growth of different investments or financial metrics, like revenue, profits, or stock prices, over time, providing a smooth annual growth rate that eliminates the impact of volatility or fluctuating performance.

Key Features:

• Constant Growth Rate Assumption: CAGR assumes that the growth rate of an investment is consistent over the period, which may not reflect actual fluctuations in year-to-year performance. It’s an average growth rate rather than a precise yearly rate.

• Compounded Growth: CAGR takes into account the effects of compounding, meaning that the growth is applied to both the principal investment and the accumulated growth over the period.

• Simple Calculation: It simplifies the calculation of growth over a period by smoothing out the impact of volatility, making it easier to compare different investments or performance metrics.

CAGR Formula:

The formula for calculating CAGR is:

Where:

• Ending Value = The final value of the investment or metric at the end of the period.

• Beginning Value = The initial value of the investment or metric at the start of the period.

• n = The number of years (or time periods) over which the growth is measured.

Importance of CAGR

• Growth Comparison: CAGR allows investors and analysts to compare the growth of different investments or financial metrics over time, eliminating the impact of short-term fluctuations or volatility.

• Simplicity: Unlike average annual returns or other growth metrics, CAGR provides a single rate of growth over the entire period, making it easier to understand the overall performance of an investment or business.

• Benchmarking: CAGR is commonly used to benchmark the performance of individual investments against market indices or other investment opportunities.

• Long-Term Performance: CAGR is particularly useful for assessing the performance of long-term investments, as it smooths out the yearly variations in returns, allowing for a more accurate reflection of the overall growth trend.

FAQ

What does a CAGR of 10% mean?
A CAGR of 10% means that, on average, the investment or financial metric has grown by 10% per year over the specified period, assuming the growth is compounded annually. This does not mean that the investment grew by exactly 10% every year, but that the overall growth rate averages out to 10% per year.

How is CAGR different from average annual return?
CAGR represents the rate at which an investment would have grown if it grew at a consistent rate each year. The average annual return, on the other hand, simply averages the yearly returns, without accounting for compounding. This means that CAGR is generally a better reflection of long-term growth when compounding is involved.

Can CAGR be used for any type of investment?
Yes, CAGR can be applied to any investment or financial metric, such as stock prices, revenue growth, or portfolio returns. It’s a versatile metric used to compare the long-term growth performance of various investments or financial indicators.

Why is CAGR important for investors?
CAGR is important for investors because it helps them assess the long-term growth potential of investments by providing a consistent rate of return, free from the impact of short-term market fluctuations. It is particularly useful for comparing investments over extended periods.

Can CAGR be negative?
Yes, CAGR can be negative if the investment or financial metric declines over the specified period. A negative CAGR indicates that the investment has lost value on average each year over that period.

Example: 

Suppose you invested $10,000 in a stock, and its value increased to $16,000 over 4 years. The CAGR would be calculated as:

This means the investment grew at an average rate of approximately 13.07% per year, compounded annually, over the 4-year period.