Compounded Annual Growth Rate (CAGR)
Compounded Annual Growth Rate (CAGR) is the compounded rate of growth or the year on year growth over a specified period of time.
Thus CAGR gives the rate at which an investment would have grown from one year to another at a steady rate.
The formulae for calculating CAGR is as follows
CAGR = (Ending or Current Value / Beginning Value) ^ (1 / # of Years) - 1
Example
For example an investment has the following values at the end of each year with annual growth.
Year - 2004, Value - $ 1,000
Year - 2005, Value - $ 1,500, Growth Rate - 50%
Year - 2006, Value - $ 1,600, Growth Rate - 7%
Year - 2007, Value - $ 1,900, Growth Rate - 19%
Year - 2008, Value - $ 2,500, Growth Rate - 32%
The CAGR of the investment for the period 2004 to 2008 is 20.1%.
This means that the investment has given a notional growth of 20.1% every year from 2003 to 2008. However in reality the growth can be more in a particular year and less in another year during this period. As can be seen above the Annual Growth Rate is 50% in 2005 whereas it is 7% in 2006.
Thus the value of investment on a year on year basis applying a steady growth rate would look like
Year - 2004, Actual Value - $ 1,000, CAGR @ 20.11% - $ 201, CAGR Value - $ 1,201
Year - 2005, Actual Value - $ 1,500, CAGR @ 20.11% - $ 242, CAGR Value - $ 1,443
Year - 2006, Actual Value - $ 1,600, CAGR @ 20.11% - $ 290, CAGR Value - $ 1,733
Year - 2007, Actual Value - $ 1,900, CAGR @ 20.11% - $ 349, CAGR Value - $ 2,082
Year - 2008, Actual Value - $ 2,500, CAGR @ 20.11% - $ 418, CAGR Value - $ 2,500
Commentary
The period for which CAGR is computed may include high and lows in the economy i.e. periods of boom and recession. This is evened out in the CAGR ratio and an overall result of the performance of an investment can be known.
For instance, during a cycle in the stock market involving a period of boom in the stock market and crashing of the stock market, if the CAGR shows a steady return it is worth holding the stock / investment of that particular company. However if the particular stock does not show a healthy CAGR after this cycle then the investor needs to consider whether it is worth holding the investment or not. It is also better to study the current returns of the investment and the investment risk before taking a decision on the basis of the CAGR.
The CAGR calculation is more meaningful when the period is for a longer duration rather than a shorter duration. Thus CAGR for a period of 5 to 10 years gives a better indication than for a shorter period of 2 to 3 years.
Use of CAGR Ratio besides Investment
CAGR can also be computed to know the performance of companies over a period of time. Thus it is a useful tool to analyze financial statements.
The performance of commodities and products over a period of time can be gauged. This will give an indication about the survival of the product in the market over a longer duration and whether there is growth in the product vis-à-vis the growth in the economy.
CAGR Calculator
The CAGR calculator can be accessed from some of the internet sites and can be used to calculate the CAGR Ratio.
One of the sites from where the CAGR Calculator can be used is Investopedia. The link to the calculator is given here.
This site also gives an interpretation of the result derived by using the above calculator.
