Investment word of the day: Compounded Annual Growth Rate — how to calculate CAGR and what are its limitations? | Mint
Source: Live Mint
Investment word of the day: Tracking your investments is essential for understanding how your money performs over time. Skipping this practice will make it difficult to know if you’re on the right track to meet your financial goals. One effective way to measure investment growth is CAGR.
What is CAGR?
The Compound Annual Growth Rate, or CAGR, is a financial metric that measures the annual growth of an investment over a period of time. It helps determine the rise or fall in investment returns for a certain period.
It highlights the average growth in investment on a yearly basis by considering profit reinvestments accrued at the end of every year.
Unlike simple averages, the CAGR takes into account the compounding effect to show the accurate performance of an investment.
It can be calculated using the formula—(EV/BV) 1/n—1, where EV is the ending value, BV is the beginning value, and n is the number of years.
Why is CAGR important?
“The CAGR is important because it enables investors to make comparisons between differing investments that have different time intervals and returns. CAGR standardizes the way performance is measured, providing convenience,” according to Bharat Mundada, Director, Mundada Finserve Pvt Ltd.
The CAGR is especially important for long-term investments.
“It smoothens the extreme fluctuating values for an asset’s annual returns, thus clearly depicting consistent growth. This is specifically useful when understanding the long-term investments made in stocks, real estate, mutual funds, and business,” he added.
When should CAGR be used?
The CAGR enables an investor to understand the historical growth trend of a particular investment over time, which further helps in financial planning. Additionally, it can be used for the following purposes, according to Mundada.
1. Comparing Investment Options: Investors use the CAGR to determine better long-term growth between several selected mutual funds, stocks, funds, or portfolios.
2. Creating financial objectives: The CAGR helps to estimate how much an investment will be worth in the future, which greatly assists goal-oriented financial planning.
3. Estimate the success of a business: Companies use the CAGR to measure an increase in revenue, profits, or market share over a period of time.
However, one of the drawbacks of CAGR is its inability to analyse intra-year volatility and market fluctuations. Hence, the CAGR cannot be used solely to estimate the growth of investments. It must be used with other measures, such as standard deviation or rolling returns to give an accurate estimate of returns.
