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Compound Annual Growth Rate (CAGR) Calculator

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Understanding Compound Annual Growth Rate (CAGR)

The Compound Annual Growth Rate (CAGR) is a vital metric used to measure the average annual growth rate of an investment or business over a specified period, assuming that profits were reinvested at the end of each year. It's a way to smooth out volatility and understand the consistent growth trend of an asset, revenue, or any other quantifiable metric. Unlike simple average growth, CAGR accounts for the compounding effect, where growth in one period contributes to growth in subsequent periods.

Why is CAGR Important?

CAGR provides a more realistic picture of growth than a simple average. For instance, if an investment grew by 50% in year one and then declined by 30% in year two, a simple average would suggest a 10% growth. However, CAGR would reveal a different, more accurate story by considering the compounding impact. It's widely used by investors, financial analysts, and businesses to:

  • Compare the performance of different investments over the same period.
  • Assess the historical growth of a company's revenue or profits.
  • Project future growth based on past performance.
  • Understand the efficiency of business strategies.

How is CAGR Calculated?

The formula for CAGR is as follows:

CAGR = (Ending Value / Beginning Value)^(1 / Number of Years) – 1

Where:

  • Ending Value: The value of the investment or metric at the end of the period.
  • Beginning Value: The value of the investment or metric at the start of the period.
  • Number of Years: The total number of years in the period.

The result is then typically multiplied by 100 to express it as a percentage.

Example Calculation

Let's say you invested $10,000 in a stock portfolio five years ago. Today, your portfolio is worth $25,000. 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, the CAGR is approximately 20.11%. This means your investment grew at an average annual rate of 20.11% over those five years, considering the power of compounding.

Limitations of CAGR

While CAGR is a powerful tool, it's important to understand its limitations. It presents a smoothed-out rate of return and doesn't reflect the actual year-to-year volatility or risk associated with the investment. An investment with a high CAGR could have experienced significant ups and downs, making it potentially riskier than an investment with a slightly lower but more stable CAGR. Therefore, CAGR should be used in conjunction with other financial metrics for a comprehensive analysis.

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