Unlocking the power of CAGR:

What is CAGR:

The compound annual growth rate (CAGR) is the mean annual growth rate of an investment over a period longer than one year. It is?one of the most accurate ways to calculate and determine returns for individual assets, investment portfolios, and anything that can rise or fall in value over time.

How To Calculate CAGR

Calculate CAGR, the following formula is used:

CAGR = (Ending Value / Beginning Value) ^ (1 / Number of Years) - 1

For example, suppose an investor invests 10,000/- Rs. in a stocks/ mutual fund, and after five years, the fund has grown to Rs. 15,000/-. Using the formula, the CAGR of the investment over the five-year period is:

CAGR = (Rs. 15,000 / Rs. 10,000) ^ (1/5) - 1 = 8.14%

Therefore, the investment grew at an average annual rate of 8.14% over the five-year period.

Let us look at an example of how to calculate CAGR for a stock investment.

Stock Investment Example:

Imagine you invested in a stock of Company XYZ at the beginning of 2019 for Rs 50/- per share. By the end of 2023, the stock price has increased to Rs.120/- per share. You want to calculate the Compound Annual Growth Rate (CAGR) of the stock price over this 5-year period.

Given:

• Beginning Value (Initial Stock Price) = Rs. 50/- per share (in 2019)
• Ending Value (Final Stock Price) = Rs. 120/- per share (in 2023)
• Number of Years = 5 years

Why is CAGR Important in Finance?

CAGR is essential in finance because it helps investors evaluate investments over an extended period, typically more than one year. It is especially useful for comparing investments with different holding periods or where returns vary from year to year.

For example, suppose an investor has two investment options: Investment A has an annual return of 10% for five years, while Investment B has an annual return of 15% for three years. In this scenario, comparing the two investments' returns based on their annual rate of return will not provide an accurate picture.

Instead, using CAGR, the investor can compare the two investments' performance accurately. Investment A's CAGR is 8.14%, while Investment B's CAGR is 13.23%. This means that Investment B has a higher long-term growth rate than Investment A, despite its shorter holding period.

Additionally, CAGR is useful in forecasting an investment's future performance. It helps investors determine if an investment is growing at a steady rate or if its growth rate is fluctuating, which can help in making informed investment decisions.

Pros and Cons of CAGR:

Pros:

• Provides a clear picture of an investment's long-term growth rate.
• Useful for comparing investments with different holding periods or where returns vary from year to year.
• Helps investors forecast an investment's future performance.
• Helps identify steady growth or fluctuations in an investment's growth rate.

Cons:

• Assumes that an investment's value grows at a constant rate each year, which may not be accurate for all investments.
• Does not consider compounding effects on returns.
• Not suitable for evaluating investments with varying cash flows or when the holding period is less than a year.

Conclusion:

CAGR is a vital metric for investors in evaluating an investment's performance over an extended period. It is useful for comparing investments with different holding periods, forecasting an investment's future performance, and identifying steady growth or fluctuations in an investment's growth rate. However, it is not suitable for evaluating investments with varying cash flows or when the holding period is less than a year. Investors should consider CAGR's advantages and disadvantages when evaluating investments and use it in conjunction with other metrics to make informed investment decisions.