Compound Annual Growth Rate (CAGR) Calculator
Understanding the Compound Annual Growth Rate (CAGR)
The Compound Annual Growth Rate (CAGR) is a vital financial metric used to measure the average annual growth rate of an investment or business over a specified period of time, assuming that profits were reinvested at the end of each year. Unlike simple average growth, CAGR smooths out volatility and provides a more representative view of an investment's performance over multiple years. It's particularly useful for comparing the historical performance of different investments or the growth trajectory of a business.
Why is CAGR Important?
- Performance Measurement: It quantifies the growth of an investment, allowing investors to assess its historical success.
- Comparison Tool: CAGR enables objective comparisons between different investments or companies, even if they have varying growth patterns.
- Future Projections: While a historical measure, CAGR can be used as a basis for projecting future growth, albeit with caution.
- Business Valuation: Businesses often use CAGR to track revenue or profit growth, which can influence their valuation.
How is CAGR Calculated?
The formula for CAGR is as follows:
CAGR = ( (Ending Value / Beginning Value) ^ (1 / Number of Years) ) – 1
To express this as a percentage, you multiply the result by 100.
Key Components of the CAGR Formula:
- Beginning Value: The value of the investment or metric at the start of the period.
- Ending Value: The value of the investment or metric at the end of the period.
- Number of Years: The total number of years in the period.
Example Calculation:
Let's say you invested $10,000 in a stock at the beginning of 2019. By the end of 2023 (a period of 5 years), your investment has grown to $25,000. Here's how to calculate the CAGR:
- Beginning Value: $10,000
- Ending Value: $25,000
- Number of Years: 5
Using the formula:
CAGR = ( ($25,000 / $10,000) ^ (1 / 5) ) – 1
CAGR = ( (2.5) ^ (0.2) ) – 1
CAGR = (1.2011) – 1
CAGR = 0.2011
As a percentage, this is 20.11%.
This means that your investment grew at an average rate of 20.11% per year over the 5-year period, assuming profits were compounded annually.
Limitations of CAGR:
While powerful, CAGR doesn't account for the volatility or risk taken to achieve the growth. An investment with a high CAGR might have experienced significant ups and downs, while another with a slightly lower CAGR might have shown steadier, less risky growth. It also assumes a constant growth rate, which is rarely the case in reality.