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 growth of an investment or a business metric over a specified period of time, assuming that the profits were reinvested at the end of each year. It smooths out volatility and provides a more representative measure of growth than simple average growth rates.
What is CAGR?
CAGR is not an actual financial accounting term but rather a common way to express growth. It represents the geometric progression ratio that provides a constant annual rate of growth if the value had grown at a steady rate. It's particularly useful for comparing the performance of different investments over time, as it accounts for the compounding effect.
The Formula for CAGR
The formula for calculating CAGR is as follows:
CAGR = ( (Ending Value / Starting Value) ^ (1 / Number of Years) ) - 1
- Ending Value: The value of the investment or metric at the end of the period.
- Starting Value: The value of the investment or metric at the beginning of the period.
- Number of Years: The total number of years over which the growth is measured.
Why Use CAGR?
- Smoothes Volatility: It provides a single, representative growth rate, ignoring the ups and downs that may have occurred during the period.
- Facilitates Comparisons: CAGR allows for easy comparison of the performance of different investments or business metrics, even if they have different historical growth patterns.
- Assesses Investment Performance: It's a standard tool for investors to evaluate the historical performance of their portfolios or individual assets.
- Business Planning: Businesses use CAGR to forecast future growth and set realistic targets.
Example Calculation:
Let's say you invested $10,000 in a stock at the beginning of 2018. By the end of 2022 (5 years later), your investment is worth $25,000.
- Starting Value = $10,000
- Ending Value = $25,000
- Number of Years = 5
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 annual rate of approximately 20.11% over the 5-year period.
Limitations of CAGR
While CAGR is a powerful tool, it's important to understand its limitations. It doesn't reflect the risk taken to achieve the growth. An investment with a high CAGR might have experienced significant volatility, whereas another with a lower CAGR might have been more stable. Therefore, CAGR should often be considered alongside other risk-adjusted performance metrics.