Compound Annual Growth Rate (CAGR) Calculator
Understanding Compound Annual Growth Rate (CAGR)
The Compound Annual Growth Rate (CAGR) is a crucial metric used to measure the average annual rate at which an investment has grown over a specified period longer than one year, assuming that the profits were reinvested at the end of each year. It represents a smoothed-out rate of return, making it easier to compare the performance of different investments over time, even if their growth patterns were volatile year-to-year.
CAGR is particularly useful because it accounts for the compounding effect of growth. Unlike a simple average, CAGR considers that returns in one period can generate further returns in subsequent periods. This makes it a more accurate reflection of an investment's true growth trajectory.
How CAGR is Calculated
The formula for CAGR is as follows:
CAGR = [(Ending Value / Beginning Value)^(1 / Number of Years)] – 1
Where:
- Ending Value is the value of the investment at the end of the period.
- Beginning Value is the value of the investment at the start of the period.
- Number of Years is the total number of years in the period.
The result is typically expressed as a percentage.
Why CAGR is Important
CAGR provides a single, representative growth rate that simplifies performance analysis. It's commonly used by investors and businesses to:
- Assess the historical performance of stocks, mutual funds, or entire portfolios.
- Evaluate the growth of revenue, profits, or other key business metrics.
- Compare investment opportunities with different time horizons and volatility.
- Set realistic future growth targets.
It's important to remember that CAGR is a hypothetical rate. It doesn't reflect the actual year-to-year fluctuations an investment may have experienced. However, it offers a valuable benchmark for understanding long-term growth trends.
Example:
Imagine you invested $10,000 in a stock (Beginning Value). After 5 years (Number of Years), your investment has grown to $25,000 (Ending Value). Using the CAGR formula:
CAGR = [($25,000 / $10,000)^(1 / 5)] – 1
CAGR = [(2.5)^(0.2)] – 1
CAGR = [1.2011] – 1
CAGR = 0.2011 or 20.11%
This means your investment grew at an average rate of approximately 20.11% per year over the 5-year period.