What is CAGR?

Investing is a detailed process rather than just an action. It requires constant monitoring, decision-making and analysis. The CAGR metric can be a useful tool for this. Its abbreviation is the Compounded Annual Growth Rate. The formula calculates returns based on the compounded final value compared to initial investment and time for this compounding. It is considered as one of the most reliable return calculation methods. However, understanding the CAGR meaning, its applications and calculation in detail is crucial to get the desired help in investment analysis.

How does CAGR work?

As time progresses, the value of money depreciates. 

• For example, the pack of biscuits available for ₹20 today may cost ₹50 after 7-8 years. This is due to inflation. However, this phenomenon positively affects the investments. 
• The investment value will grow after some years, considering the rest factors are constant. This process is known as compounding.
• In such a case, calculating normal returns may not be helpful. 

Therefore, Compounded Annual Growth Rate (CAGR) provides the average rate of the given period of growth. It is represented in the CAGR full form. Its calculation is as follows:

CAGR (%) = [((F.V./I.V.)^(1/N) – 1)*100]

Here, 

> F.V. = Final Value of an Investment

> I.V. = Initial Value of an Investment

> N = Time or Number of years

Factors to Consider while Using CAGR

Understanding what is CAGR meaning would require investors to consider factors affecting while using it for return calculation. Some of these factors are as follows:

• Time is a crucial element of its calculation, and it should be selected carefully as the result will vary with its selection.
• The risk of market fluctuations cannot be considered in this calculation.
• CAGR does not guarantee or predict future performance and is a represented average of the overall performance.
• It can be used to compare the performance across different instruments or sectors.

How is CAGR Helpful in Asset Performance Appraisal?

Calculating asset performance and its appraisal helps an investor make buy, sell or hold decisions for an asset. CAGR can be specifically helpful in this process in the following ways:

• It may not guarantee the returns but helps understand the possible future growth trajectory of an asset’s performance.
• It explains or indicates the required period for the growth of an investment, mainly in the long-term scenario. It can be helpful in retirement planning.
• Investors can also analyse the business operations by analysing the factors such as reduction in sales, increase in expenses, purchase of new assets, etc., that are affecting the business in a year, which has growth rate lower than the CAGR. 
• Comparison is simplified due to CAGR.
• Risk-adjusted returns calculated parallel to CAGR can be used in analysing the performance.

What is a Good CAGR?

There is no specific benchmark for a good CAGR. It depends on various factors, such as investment period, instrument, sector, economic conditions, etc. Moreover, the comparison can also indicate the good or required CAGR for an asset.

What is Negative CAGR?

When an asset incurs negative returns or losses for a significant period, its CAGR becomes negative. Moreover, if an investment has grown in a period but its final value is less than the initial value, then the CAGR can be negative.

For example, ₹500 is invested in an asset initially. For the next 5 years, it increases as follows:

• Year 1: 550
• Year 2: 600
• Year 3: 625
• Year 4: 530
• Year 5: 460

Here, CAGR = [(460/500)^(⅕)] -1 = (0.016) = -1.6%

Use of Compounded Annual Growth Rate (CAGR)

Understanding the CAGR meaning can help apply it to different assets. Investors can use it for the following purposes:

• Investment analysis
• Relative profitability
• Asset comparison
• Setting financial goals
• Smoothens volatility

What is CAGR in Stocks?

The stock market is one of the avenues for calculating stock returns with a CAGR. This metric balances the volatility, which is an inherent feature of the stock market. Generally, a stock may seem to be performing well, but if investors calculate its CAGR, one can get a clear view of the returns. Let’s understand it with a hypothetical example.

Mr K invests ₹250 in stock, and its price fluctuates as follows:

> Year 1: ₹220

> Year 2: ₹300

> Year 3: ₹375

Rate of Return = [((F.V. – I.V.)/I.V.)*100]

Rate of Return = ((375-220)/220)*100 = 70.455%

CAGR = [((F.V./I.V.) ^ (1/N)) – 1]*100

CAGR = [((375/220)^(⅓)) – 1]*100 = 19.452%

The CAGR is less than regular returns because it accounts for the aspect of time. Investors can use such information to foresee future growth and decide their entry-exit in a particular stock.

What is CAGR in Mutual Funds and How Does it Work?

Investors can use CAGR in mutual funds to calculate the returns only in the following condition:

• Lump sum investment is only considered. Systematic or part investments and withdrawals may affect the calculation.
• CAGR cannot predict the future performance of the funds. It is affected by multiple factors.
• The long-term outlook of a fund can be understood by CAGR. However, short-term CAGR can be misguided.

Investors can use the performance metrics of CAGR in mutual funds to compare different funds and select the suitable type. Let’s understand with an example:

Ms N invested ₹10,000 in equity mutual funds. Its NAV at the time of investing was ₹250, and she got 40 units of the fund. After 4 years, the NAV is ₹500. 

Now, the investment value will be ₹20,000 (500*40). Here, 

CAGR = [(20,000/10,000)^(¼)] – 1 = 0.1892 = 18.92%

Limitations of CAGR

This return calculation metric is quite useful, but it is accompanied by some limitations, such as:

• Volatility is not reflected to ascertain the real risk of an asset.
• It cannot predict future performance despite considering time.
• Solely relying on CAGR may not be beneficial when external factors can affect an investment significantly.
• For instruments like mutual funds, the frequent investment or withdrawal with Systematic Investment Plan (SIP) or Systematic Withdrawal Plan (SWP).

Conclusion

Compounded Annual Growth Rate or CAGR is a crucial metric, which can help compare or analyse the assets. Mainly, it includes the time factor in the calculation of returns to get the real picture of an investment. However, investors need to evaluate its application, and limitations to avoid relaying their overall prediction based on it.

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FAQs on CAGR

1. Does the calculation of CAGR remove the risk of return variations because of stock market instruments?

Ascertaining risk and its effect on the returns requires spread or variation analysis. CAGR only provides an average growth rate while accounting for any variability in the returns. Therefore, it is not concerned about the risk of return variations.

2. What does CAGR mean in investment analysis?

The time value of money plays a crucial role in determining the returns against the depleting money value. CAGR considers this aspect and depicts an average growth rate of investment in the given period. Such analysis helps get a clear picture of actual market returns.

3. Does CAGR predict future performances?

A CAGR is a metric to calculate returns or know the possible returns for a future period. However, an instrument can be affected by multiple factors. Therefore, CAGR will not specifically predict guaranteed returns for future performance. 

4. How does CAGR calculation help a stock market investor?

Calculating the average returns based on the time value of money can help ascertain the actual performance and capacity of a stock. Moreover, stock market investors can base their entry or exit decisions on this result.