Wondering what is cagr because you would like to calculate returns or have an idea of future investment growth? Read till the end to know everything about cagr, how to calculate it, the formula, and how it is more suitable than most other metrics.
Want to invest in real estate, but you do not know how to track the progress on returns because hardcore math or financial technicalities are not your cup of tea? Don’t worry!
This happens with most people from non-mathematics or finance backgrounds, but does this mean you will always have to hire someone for returns analysis, like every single time you want to know how your investment is doing in the market?
This sounds gloomy because no one has the time and the money to hire a professional for returns analysis of an investment made to save money! It is simply non-practical. No need to panic; you can do this independently without hiring someone for handsome money. It is so simple with the CAGR formula that you can do it in the middle of the night, rummaging through your financial investments.
Yes! The same old CAGR. This is your elementary, straightforward, and easy to compute formula for determining your investments’ growth rate over time. The compound annual growth rate (CAGR) gives a relatively very detailed picture of the journey of the investment that it goes through from the start till the end. It considers the time factor, which means you do not get an average of the increase on the investment, but an accurate picture of the growth made through the years.
Without considering the time factor, the returns analysis is skewed and erroneous, and the picture that comes to the surface will present a misleading reality. The simplicity and detail factor of the CAGR formula make it famous.
If you have investments in various places and would like to calculate and assume returns on them by yourself, then read till the end. This article sheds light on every aspect of CAGR and clarifies all complications there can be.
What is cagr?
Compound annual growth rate, or CAGR, is a mathematical formula used to compute investment returns over a period of time. It represents an investment’s mean annual growth rate (smooth and uninterrupted ) for a particular period, but it has to be longer than one year. CAGR is usually thought to be one of the most accurate ways to calculate and determine returns for individual assets, investments, or anything that faces the probability of rising or falling in value over time.
Investment advisors use this term quite frequently when they have to impress how certain investments are great, but what does the term really show?
The CAGR predicts a “smoothed” rate of return, and the most important thing to note, as an investor, is that its predictions do not take into account volatility or risk factors. A pro forma number explains what an investment is likely to yield on an annually compounded basis. This indicates what they can expect from their assets at the end of the investment period.
Here is an example. Just assume you invested $1,000 at the beginning of the year 2017, and by the end of the same year, your investment sat at $3,000, showing a 200 percent return. The following year, the market slowed, and you ended up losing 50 percent — with the end product of $1,500 at the end of 2018.
What was the return on your investment for the investment period? Using AAR or average annual return does not seem viable in this scenario. The average yearly return on this investment was 75% (200% gain and 50% loss), but the accurate picture is a little different. In these two years, the result was not $3,065 as expected, but $1500 actually ($1,000 for two years at an annual rate of 75 percent). To determine your actual annual return for the stipulated period, you will use the CAGR formula.
CAGR is the rate of return for the value of an investment growing from its initial value to the end value between two dates.
This is the primary question that CAGR answers for you:
“What is the rate at which the financial metric must grow at each hallmark (period) to reach the final positions starting from one date and ending at a specified other?”
CAGR = [EV / BV]^1/n – 1
The three necessary values of the CAGR formula are listed below.
- Beginning Value
- Ending Value
- Number of Periods (n)
Why is compound annual growth rate (CAGR) advantageous?
The Compound Annual Growth rate is hardly an irrelevant, highly technical term that has no meaning or use for a layman. This is a commonly used term in the mutual fund industry. It’s something every business person or a shareholder must know because this is that formula that you can employ to measure and compare the performance of your company’s investments.
CAGR assumes and predicts a constant growth rate across the period under consideration, which usually doesn’t reflect reality because that’s not how investments work in the real world. By eliminating volatilities and inconsistencies of investment growth, it’s easier to compare different investments or track their performance.
How to calculate CAGR for your investments?
Most investors like to analyze their investments in absolute terms. This gives them a more authentic feeling as the risks and volatilities are included in the analysis. However satisfying the process may be, these analyses do not calculate the time value of money. In contrast, CAGR considers the time for which the investment was used.
CAGR gives you an approximate rate at which your investment would probably grow in the absence of volatilities. It is an easy yet superb way to factor in and out (according to the situation) the asset’s fluctuations during the investment period. With CAGR, you can easily calculate the actual performance of your investment and not be confused by the risks and losses.
It is one excellent way to estimate how a given investment performed compared to its price. You can calculate CAGR in three easy steps. These are the three values to know while calculating the CAGR value.
- The investment made in the initial year (the first year of investment)
- Value of investment at the end of the year
- Tenure of investment You can calculate CAGR using our CAGR Calculator as well.
Compound annual growth rate & mutual fund returns
When putting your money in mutual funds, you need to be careful. You need to do your math because it’s your investment, and having an idea of how things might work helps. You should have a clear picture of how things are supposed to work and if the investment is even worth all the trouble or not! You need to measure its performance for a stipulated period of time.
The mutual fund fact sheet always gives growth rates across various time horizons, but it gets a little tricky for investors to judge the fund performance when it’s shown in multiple ways. It would be so convenient to know how it grew annually.
This is precisely where CAGR will help you as an investor. It will provide you with a single annual growth rate that will explain how your investment is likely to behave and perform over the period of time of its withholding. In addition, it brings compound interest to the forefront. Usually, the compound interest remains in the background, although it’s one primary metric in analyzing an investment. Most investment avenues and mutual funds use compound interest to calculate investment returns.
So, CAGR is your best option for measuring fund performance.
What should investors know about CAGR?
As an investor, you should have an obvious idea of what you will get when you apply CAGR. While it’s an excellent indicator of your investment’s performance, there are some limitations. It gives you a straight, smooth value of performance for a certain period of time but offers no details about how it happened.
Here are a few important things to know about CAGR:
- The CAGR does not offer any explanation of sales that happened from the starting year to the last year. It shows the end product without showing the journey of the investment. In some cases, entire growth may have happened in the first year or at the expiry of the term.
- Sometimes, two investments can have the same CAGR, while one is more profitable than the other. The reason could be the differential growth rate during the investment time like perhaps one grew in the first year and the other made progress only later half of the second year.
- A CAGR is mainly used when an investment is for three to seven years. It predicts and analyzes the growth rate perfectly for this period. If the asset is for more than this period, like it was for ten years, then the CAGR will give skewed ideas of the sub-trends between the years.
- Keep in mind that Compound Annual Growth Rate is different from your year-on-year growth rate.
Other ways to determine returns
CAGR is not the only way of analyzing an investment in mutual funds; there are other ways that give a fruitful analysis of the situation and help clarify the picture immensely. They may be used in addition to CAGR to gather investment information from various angles.
1- Annualized returns
Annualized returns present the average amount of returns that investment creates every year for a particular period. Annual returns highlight the return rate an investor is likely to earn or earn in a specific period, calculating the annual compounding of returns. This clarifies the picture and tells a lot about how the investment would probably behave without counting on the market volatility of markets.
An annualized return provides only a quick snapshot of the overall performance of an investment without giving any details of volatility or price fluctuations, which are part and parcel of the market.
2- Trailing returns
If you want to know about your investment history, you can go for the trailing return analysis. This is the best way of calculating the performance of your funds on a daily, weekly, monthly, or annual basis; you can track the historical record of how things went day by day, week by week, or month by month.
The trailing returns method is perfect for a one-time investment. If you invest an amount on 17 April 2019, the 1-month trailing return period will range from 17 April 2019 to 17 May 2019.
3- Return since launch
One can ascertain the value of return since launch from the time an NFO (New Fund Offer) gets closed. They calculate it at a first Net Asset Value of Rs 10.
The most significant benefit is that it serves as a quick and informative catalog on the growth of anything that rises (or falls) in value like an investment, an asset, or a financial metric. You can also ascertain if the projections of benefits or returns are actually in line with the average industry returns. This helps you make rational and logical decisions regarding investments.
The clear and simple return expectations or performance report that CAGR gives helps even a layman get the hang of investment in mutual funds.
Let’s suppose a company is supposed to grow at a CAGR of 20%, but its closest comparables or even competitors are showing around a 5% growth rate in the same time period. The overall industrial forecast sits at 3% throughout. In this case, the company’s growth assumptions show a need for adjustments. In any case, experts need to take a closer look at the numbers shown in the reports to assure everything is alright.
Since annualized growth metrics get rid of the fluctuations of year-over-year growth rates and simplify performance reports, this helps the comparisons of CAGRs over time of two companies or investments. Such a comparison can be extremely challenging without a CAGR report.
CAGR allows risk-free instruments to measure returns from a particular investment. It also helps determine if the risk-taking premium is sufficiently high.
The main downside of the CAGR is that it does not consider the volatility, fluctuations, and risks associated with the underlying asset. It assumes a relatively unchanged rate of growth. This means there is considerable room for overly optimistic expectations and widely misinterpreted returns. The actual growth rate will have to face all the unavoidable fluctuations of the market. The real growth rate varies from the CAGR predictions in most cases.
The CAGR can be misleading by erroneously portraying that a certain company has consistent and linear growth potential. For instance, a company may have done business with significant profit at the beginning of the investment period, and the latter half was dreary or flat. The curve may be flattening towards the end, which is very important for the investor to know. The CAGR will show the company to have an overall growth throughout the time period without taking a closer look,
Another drawback is that the CAGR does not consider the inflows and outflows to measure its total profitability. Instead, the CAGR measures the return rate based on the portfolio’s initial and final balance.
Applications of CAGR formula
The CAGR formula can be used in the following scenarios to analyze your investment decisions:
- If you bought some specific units in equity funds and also increased the value of the fund. With the CAGR formula, you will be able to calculate the rate of return of your investment. The formula is so simple; you can do the math on your own.
- You want to start investing and require specific objectives to stay focused. Using the CAGR formula, you can determine at which rate your money should grow and give profit to meet your particular goals.
- If you are thinking about making multiple investments in equity funds at different percentages and for various periods of time like for 3, 5, and 10-year with the returns of 30%, 18%, and 12%, respectively. CAGR is perfect to know the average annual growth rate of your account.
- Comparing an investment’s CAGR with the return rate of your expectation to see if you consider an investment viable. Invest only if the CAGR matches your expected return value.
- You can equate the CAGR of a mutual fund with a benchmark return to see if it’s going well on the market.
CAGR vs. IRR: what’s the difference?
The internal rate of return (IRR) is another metric used to evaluate the profitability of potential investments. As an investor, you would like to know if a prospect is worth the effort and money or not. Several metrics analyze the returns on investments and study them from multiple angles. Two famous analytical tools or formulas are IRR and CAGR.
IRR analyzes the investment in a way that the net present value (NPV) of all cash flows is assumed to be zero in a discounted cash flow analysis.
IRR calculations use the same formula as NPV does. Keep in mind that IRR is not the actual dollar value of the project. It is the annual return that makes the NPV equal to zero.
For general understanding, you should know that a higher rate of IRR means an investment is worth the risk. IRR stays the same or predicts even results across the various types of investments. In general, when the task is to compare two projects or investments that show the same characteristics, IRR is thought to be the best metric.
Outwardly, the CAGR and IRR (internal rate of return) may look identical as they both can predict the growth rate of investments over a period of time, but there’s a vital difference that calls for a more profound and thorough understanding of the topic.
Although IRR and CAGR both measure the performance of your investments, IRR comes with much more flexibility than CAGR. Both formulas calculate the returns of assets, but CAGR’s formula only includes one initial investment (cash outflow) and one ending amount (cash inflow).
In complete contrast to this, IRR measures multiple cash inflows and outflows while analyzing investment return. This feature makes the IRR analysis a little more detailed and explanatory.
Because of this versatility, the IRR is often used to estimate the expected profitability of proposed projects. IRR is a great favorite with venture capital firms, which use it all the time to analyze the growth of company acquisition targets.
One of the most remarkable characteristics of compound annual growth is its simplicity. The formula is so simple that one can manage the calculation on fingers. With IRR, analysis is very complicated, which is why IRR is used to evaluate more complex projects.
What is the difference between absolute return and CAGR?
Investments are not for fun; they are always for money and profits. Whenever someone is investing, they will like to know how the outcome might impact the actual value and the benefits earned at the end of a particular time period. To predict how investments will do, various analytical formulas are employed. IRR, CAGR, and Absolute Returns are examples of those metrics or formulas that indicate returns on investments.
The CAGR takes into account the time factor, so it’s safe to assume that the CAGR predictions are much more practical and reliable than the simple absolute returns.
The formula for absolute return
((Current value of the investment/ Initial investment) – 1) * 100.
It is evident from the formula that returns calculation is a simple matter for absolute returns.
Example for Absolute return Vs. CAGR
If you are investing your money for the first time, you will need to go through a few examples to get the hang of the whole thing. Math or formulas may not make much sense to you. To understand the difference between absolute return vs. CAGR compounded annual growth rate, clearly consider this example:
Let’s say Mr. Thomas invested a $5,00,000 lump sum in a mutual fund in 2000. He withdrew his investment in 2010 while the value of the investment had risen to $8000
The absolute return for Mr. Thomas is ((8,00,000/5,00,000) – 1) * 100
Absolute Return = 60%
the CAGR for the same investment is ((8,00,000/5,00,000)^(1/10)) – 1
CAGR = 4.81%
The example clarifies so much; if you were wondering how CAGR and absolute returns are different, then the example explains it well. The absolute returns show just how much the investment grew, regardless of the time it was held for, leading to skewed positivity. An investor, who is not aware of the reality of absolute returns, can easily be tricked into thinking the investment did wonders because it grew by 60%, Whereas, in fact, it only grew by 4.8%.
The CAGR is used to determine the average growth of an investment over the years. It considers the initial income and latest amount and the time period it was held for, while calculating returns and average investment growth. Market forces dictate change; returns cannot stay uniform for long. Therefore, the analysis should allow price fluctuations and devaluations to give more accurate returns.
For example, an investment might grow by 12% one year but depreciate for the next by growing only at 5%. CAGR calculates the average, smoothes out the fluctuations, and gives a simplified, clear picture of the returns. It is also a great way of analyzing different investments.
CAGR is clearer than absolute returns, whereas, IRR gives even more detail than CAGR.
Which is better, CAGR or absolute return?
Both absolute returns and compounded annual growth rate are valuable metrics for determining the returns from an investment. They both differ in the aspect of time consideration. For assets with longer durations, the CAGR value is a better measure. It gives a more detailed explanation of what happened during the period and tracks the rate at which investment might have grown.
CAGR determines an investment’s annual growth rate and considers the fluctuations it faces during the investment tenure. The absolute returns do not dig deep at all; in this kind of analysis, only an investment’s purchase and sale value are considered during the calculation period.
Absolute returns analysis will work for short-term investments, like those expected to stay for a year or less. The predictions made with the absolute returns formula will be worthy of consideration, assuming the acquisition did not see any extraordinary changes/fluctuations during the few months of its tenure.
However, if you are investing for any time longer than a year, you should choose CAGR reviews. This will help you better understand the returns to expect on your investment. With CAGR, you can even compare your multiple investments. Most people have more than one as they like to diversify their investments. With less than one year tenure, CAGR may inflate or shrink the returns unrealistically or erroneously, therefore, not giving the actual return.
Investments always come with the expectations of benefits and growth, and there are quite a lot of fears pertaining to receiving a loss at the end or even losing the amount altogether. To put these concerns to rest, there are various metrics for analyzing returns on investments; CAGR is one such metric that gives an average of the growth rate on an investment in a specific period of time.
In a nutshell, CAGR is far more reliable than many other metrics to track the growth of an investment. CAGR is simple to calculate and still offers a relatively detailed picture of the increase or depreciation of investment. The annual return rate doesn’t consider the compounding factor, leading to overestimation, IRR is a little more complicated for shorter investment tenure, and absolute returns predictions are too simple. Thus, CAGR comes in very handy when you need to get a quick but detailed idea of an investment’s growth rate and compare more than two. The best part is that the CAGR formula is simple; you can calculate and determine the returns on your investments by yourself. There is no need to even go for professional services.