Compound Annual Growth Rate (CAGR) Calculator
Understanding Compound Annual Growth Rate (CAGR)
The Compound Annual Growth Rate (CAGR) is a crucial metric for understanding the average annual growth of an investment or a business over a specified period, assuming that profits were reinvested at the end of each year. It smooths out volatility and provides a single, representative rate of return.
Why is CAGR Important?
CAGR is widely used because it offers a more accurate picture of performance than simple average growth. It accounts for the effect of compounding, meaning that returns in subsequent periods are earned not only on the initial investment but also on the accumulated gains from previous periods. This makes it an excellent tool for:
- Investment Analysis: Comparing the performance of different investments over time.
- Business Valuation: Assessing the historical growth trajectory of a company.
- Forecasting: Projecting future growth based on past performance.
- Performance Evaluation: Understanding the compounded growth of revenue, profits, or any other key metric.
How to Calculate CAGR
The formula for CAGR is:
CAGR = (Ending Value / Beginning Value)^(1 / Number of Years) – 1
Let's break down the components:
- 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 duration of the period in years.
The result is typically expressed as a percentage.
Example Calculation
Suppose you invested $10,000 in a stock five years ago, and today its value has grown to $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 that, on average, your investment grew by 20.11% each year over the five-year period, taking compounding into account.
When to Use CAGR
CAGR is most effective when you need to understand the smoothed growth rate over multiple periods. It's particularly useful for comparing investments with different time horizons or different compounding frequencies, as it standardizes the growth rate to an annual figure. However, remember that CAGR is a historical measure and does not predict future performance. It also doesn't account for the risk associated with an investment.