CAGR (Compounded Annual Growth Rate)

What is Compounded Annual Growth Rate (CAGR)?

Compounding interest is said to be the 8^th wonder of the world. One who understands earns and one who doesn’t pays.

If you are in the financial world, then you may have heard that this company’s CAGR is this, or this company’s CAGR is 12%, 14%, 20%…

CAGR tells you how much growth your investment has given you each year. Compound Annual Growth Rate is the rate of return required for an investment to grow from its initial value to its final value, assuming the profits were reinvested at the end of each year of the investment’s lifespan.

Before understanding CAGR, let’s know how many ways you can calculate your returns rate. The first is Absolute returns, and the second is Annual returns.

Absolute Returns

Absolute returns mean the total return your trade or investment has given, in which no time period is considered. 

Absolute Returns = ((Final value – Initial value)/Initial value) x 100

Suppose you had invested Rs. 1,00,000 in a company and it increased to Rs. 1,50,000 in 5 years.

Therefore, absolute returns (%) = ((150000-100000)/100000) x 100 = 50%

It means you have earned a total of 50% returns in 5 years in that company. This is called absolute returns. But it only shows you the total. It doesn’t tell you how much returns you have earned each year on an average. Absolute returns can mislead you some time if you want to compare two investments as no time period can be seen in absolute returns. For that, we take annual returns.

Annual Returns

Annual Returns are also of two types:

(i) Simple Annual Growth Rate (SAGR), and (ii) Compound Annual Growth Rate (CAGR)

SAGR= Absolute Return/n, where n= time period

If you divide 5-year returns with the period, it comes to 10%.

Therefore, SAGR= 50/5=10%

It tells you this much money you have earned every year, but it doesn’t tell how much growth has happened. For this, we take the Compound Annual Growth Rate. It tells you by how much percent your money has grown.

Simple Annual Growth Rate (SAGR): 10%

i.e., (0.10 x 100000) = Rs.10000 added each year

100000 ⇒ 110000 ⇒ 120000 ⇒ 130000 ⇒ 140000 ⇒ 150000 

Compound Annual Growth Rate (CAGR): 10%

i.e., money growing at 10% at each year-end

100000 ⇒ 110000 ⇒ 121000 ⇒ 133100 ⇒ 146410 ⇒ 161051

How to Calculate Compound Annual Growth Rate?

CAGR = ((Future Value/Initial Value)^(1/n)-1) x 100

Therefore, CAGR= ((150000/100000)^(1/5)-1) x 100 = 8.44%

Future value, which is your today’s value, which is Rs.1,50,000 divided by initial value Rs.1,00,000 raised to the power 1 divided by your time period, which is 5 years, minus 1. So, if you put it in the above formula, this amount comes to 8.44%. And Compound Annual Growth Rate is always expressed in terms of percent. You may not be able to calculate this 8.44% manually. You can calculate it either on a scientific calculator or in Microsoft Excel.

So, you had put Rs.100000 in the first year. If your money has grown by 8.44% each year, then your amount will be Rs.150000 at the end of the 5th year. It tells you that slowly, your money grew by 8.44% each year. So, 8.44 CAGR means that if you have put Rs.1,00,000, then at year-end, your amount has become Rs.1,08,440. Now, your return will not be calculated at Rs.1,00,000, but on Rs.1,08,440, whereas in simple annual returns, we were calculated 10% only on Rs.1,00,000 and increasing it. 

Compound Annual Growth Rate (CAGR): 8.44%

i.e., money growing at 8.44% at each year-end

100000 ⇒ 108440 ⇒ 117592 ⇒ 127517 ⇒ 138279 ⇒ 150000

Simple Annual Growth Rate (SAGR): 10%

i.e., (0.10 x 100000) = Rs. 10000 added each year

100000 ⇒ 110000 ⇒ 120000 ⇒ 130000 ⇒ 140000 ⇒ 150000

Conclusion

We use CAGR to compare any business figures like sales, profits, etc., and any investments like stocks, mutual funds, etc. CAGR varies year-to-year. Because returns for any company are never constant, sometimes, they give you positive returns, sometimes they give you negative returns. You should not calculate CAGR for a very long period of time. Suppose you are seeing the CAGR of a company for 15 years, which is around 17%. So, you may be thinking that the company is still giving you a 17% growth. But, it may not be the case. That company might have given good growth in the initial five years and might not have given the growth in the next ten years. So, it may have presented the wrong picture of the company to you. Hence, you should observe growth for recent time. CAGR helps you to follow the trends of a company. And it tells you that if the company will move in that direction or not.

Also Read:

• XIRR (Extended Internal Rate of Return)