Compound Annual Growth Rate (CAGR) Calculator
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Understanding Compound Annual Growth Rate (CAGR)
The Compound Annual Growth Rate (CAGR) is a powerful metric used to determine the average annual rate of return of an investment or a business metric over a specified period longer than one year. Unlike simple average growth, CAGR accounts for the effect of compounding, meaning that the growth in each period is applied to the new, larger balance from the previous period.
Why is CAGR Important?
- Smooths Volatility: CAGR provides a steady, smoothed-out growth rate, making it easier to understand the overall trend of an investment or business performance, even if there were significant fluctuations year-to-year.
- Comparison Tool: It allows for a standardized comparison between different investments or business segments with varying growth patterns over different timeframes.
- Forecasting: CAGR can be a useful, albeit simplified, tool for projecting future growth based on historical performance.
How to Calculate CAGR
The formula for CAGR is as follows:
CAGR = ( (Ending Value / Starting Value) ^ (1 / Number of Years) ) - 1
Let's break down the components:
- Starting Value: The initial value of the investment or metric at the beginning of the period.
- Ending Value: The final value of the investment or metric at the end of the period.
- Number of Years: The total number of years over which the growth occurred.
Example Calculation
Suppose you invested $1,000 at the beginning of 2018, and by the end of 2022 (a period of 5 years), your investment had grown to $2,000.
- Starting Value = $1,000
- Ending Value = $2,000
- Number of Years = 5
Using the CAGR formula:
CAGR = ( ($2,000 / $1,000) ^ (1 / 5) ) - 1
CAGR = ( 2 ^ 0.2 ) - 1
CAGR = 1.1487 - 1
CAGR = 0.1487
To express this as a percentage, multiply by 100:
CAGR = 14.87%
This means your investment grew at an average annual rate of 14.87% over the 5-year period, accounting for compounding.
Limitations of CAGR
While CAGR is a valuable tool, it's important to be aware of its limitations. It assumes growth occurred at a steady rate, ignoring the actual year-to-year volatility. It also doesn't account for reinvestment of earnings or the timing of cash flows within the period.