Investing wisely is crucial for financial growth and stability, and one of the most important metrics to understand in the world of investments is the Compound Annual Growth Rate (CAGR). This metric helps investors assess the growth rate of an investment over a specific period, providing a clearer picture of its performance. In this article, we'll delve into what CAGR is, how it is calculated, and why it is an essential tool for investors.

What is CAGR?

CAGR stands for Compound Annual Growth Rate. It is a percentage-based metric used to determine the annual rate of growth of an investment over a period of more than one year. It is a useful measure that describes the geometric progression ratio that provides a constant rate of return over a time period. Essentially, it represents one of the most accurate ways to calculate and determine returns for anything that can rise or fall in value over time.

Compound Annual Growth Rate is often used to compare the past performance of investments or to project their expected future returns. Unlike simple average returns, CAGR accounts for compounding, making it a more accurate reflection of an investment’s annual return.

CAGR for Mutual Funds

In the situation of an investment route such as mutual funds, you ought to find out whether or not it is worth investing. For a given period of time, you need ways to measure your progress. The mutual fund's fact sheet will provide the growth rates across varying time horizons. It can appear confusing to judge the fund's performance depending on several variables. On the other hand, if you understood the returns that the fund has generated over varying time periods, it would be better.

Compound Annual Growth Rate (CAGR) can be of aid here by supplying you with a single average growth rate. The power of compounding interest is placed in the CAGR. Most investing methods, like mutual funds, use compound interest to calculate returns. Therefore, CAGR would be an appropriate means of calculating the quality of the investment.

Compound Annual Growth Rate (CAGR) Calculation

To measure Compound Annual Growth Rate, you'll need three values—

Investment's starting value (BV)

Ending value (EV) of the investment

Tenure on investment (n)

Formula of CAGR

Using the following mathematical formula, Compound Annual Growth Rate (CAGR) can be calculated:

CAGR = [(Ending value / Starting value)^(1 / N)]-1

Three factors, namely the starting value, the ending value, and the number of years (N), affect the value of the CAGR.

The CAGR calculator will give you the rate of return on investment when you enter the three variables above.

For instance, if we hypothetically say that over the previous 5 years, Reliance Industries Ltd. experienced a compound growth rate of 31.5% in market capitalization, while earnings rose at 22% CAGR. This means that over the last five years, the total market capitalization has risen at 31.5% per year, while earnings have seen a total year-on-year increase of 22%.

Features of Compound Annual Growth Rate (CAGR)

Compound Annual Growth Rate is one of the most accurate methods of calculating the return on an investment over the investment cycle as it averages out increases and decreases in value over the investment horizon.
CAGR helps investors compare investments over multiple time horizons.
It is the most popular and commonly used method
When used over longer time periods, CAGR smoothes out short-term shocks.

CAGR vs Absolute Returns

Absolute return is the total return from the date of investment till the current date. The absolute return shows the total increase or decrease in the investment over a period of time in percentage terms. While CAGR is the annual rate of the return on investment. CAGR shows by which rate the investment has grown annually over a period of more than 1 year. Along with the annual return, CAGR also includes the effect of compounding in the return.

The formula to calculate the absolute return vs CAGR are:

Absolute Return = [(Current value of investment/Investment Value) -1] * 100

CAGR = [(Current value of investment/Investment Value) ^ (1 / N)] - 1 * 100

Let us understand this with an example:

Rs.100 invested in 2016 is now Rs.500 in 2021.

Absolute return = [(500/100) - 1] * 100 = 400%

CAGR = [(500/100) ^(1/5)] -1 * 100 = 37.97%

	CAGR	Absolute returns
Meaning	It shows the average annual returns over a period of time of more than one year	It shows the total increase and decreases in the investment from the date of investment till the current date
Use	Helps to calculate the annual return from an investment	Helps to calculate the total return from an investment
Formula	*[(Current value of investment/Investment Value) ^ (1 / N)] - 1 100**	*[(Current value of investment/Investment Value) -1] 100**

CAGR vs Mutual Fund Returns

Mutual fund returns can be calculated through various return metrics like Compound Annual Growth Rate (CAGR), absolute return, annualized return, price return, rolling returns, and many more. There is no specific method used for calculating the returns on a mutual fund investment. The investors can use different return metrics to assess & analyze the returns on an investment. Each formula will offer a different kind of view on the gains on investment.

Conclusion

Compound Annual Growth Rate (CAGR) is undoubtedly one of the best formulas to evaluate and compare different investment performances over time. Since it is a calculation of the compounded return, it takes care of the limitations of arithmetic average returns. Investors can compare the CAGR to evaluate how one investment has performed versus another, or against its benchmark, over a period of time. The CAGR is not only used to compute the returns on funds but can be used to calculate the average annual returns for any investment instrument, including stocks, bonds, fixed deposits, or even real estate.

However, CAGR does have one big limitation. It does not reflect the risk or volatility of the instrument in any way. So, even if you have a higher return in one instrument such as a small-cap equity mutual fund, and a lower CAGR in a large-cap fund, it does not imply that the small-cap fund is better. This is because it has in no way defined the risk taken to achieve a higher return.

There are some other return calculation methods which compute risk-adjusted returns, such as, Sharpe Ratio and Information Ratio which may be better options for comparing returns.

Frequently Asked Questions (FAQs)

1. What is CAGR?

Full form of CAGR is Compounded Annual Growth Rate. It is used to calculate the average annual rate of return over a period of more than 1 year.

2. How to calculate CAGR for an investment?

There is a simple formula that is used to calculate the CAGR for an investment. The formula is:

CAGR = [(Current value of investment/Investment Value) ^ (1 / N)] - 1 * 100

3. What is the difference between the CAGR and Absolute Return?

CAGR shows the annual return for over a period of more than 1 year while Absolute return shows the total return from the date of investment till the date investment was held.

4. Which return metric is better to compare returns?

CAGR and absolute return are the most used ways of comparing returns between investments. But there is a point that to compare the absolute returns of two different investments, the holding period should be the same for both the investments to have the right results.

But if the holding period is different for the investments then the best way would be to compare returns with the CAGR of investments.

5. Does CAGR return reflect the investment risk and volatility?

No, CAGR doesn’t reflect the risk and volatility of the investment. This is a limitation of the Compound Annual Growth Rate. It only shows the annual rate of return for the past performance of an investment.