The Compound Annual Growth Rate (CAGR) is a powerful tool that every investor and financial analyst should be familiar with. Find out what exactly this concept means and how it works by reading the explanation below!
What Is CAGR?
CAGR represents the rate of return (RoR) needed for the investment to grow to the final balance, assuming that any profits earned during each investment period were reinvested.
What You Need To Know About CAGR
To understand the CAGR definition better, you need to know how its value is calculated. The process entails dividing the ending value of an investment by its beginning value, taking the nth root of that number, and then subtracting 1. The nth root represents the number of years in the investment period.
For example, if an investment grew from $100 to $150 over a five-year period, the CAGR would be calculated as follows:
CAGR = (Ending value / Beginning value)^(1/5) – 1
CAGR = ($150 / $100)^(1/5) – 1
CAGR = 8.14%
This means that in this example, the investment grew at a CAGR of 8.14% over the five-year period.
Overall, CAGR is a useful tool for investors to evaluate the performance of an investment over a specific period of time. Unlike other measures of investment performance, such as total return or average return, CAGR takes into account the effect of compounding, which can significantly impact the growth of an investment over time.
CAGR can also be used to compare the performance of different investments over the same time period. By calculating the percentage for each investment, investors can see which of them performed better on an annualized basis, regardless of their initial amounts.
However, keep in mind that CAGR is not a perfect measure of investment performance. This is due to the fact that CAGR assumes that the investment grows at a constant rate over the given period, which is rarely the case in real-world investing.
In addition, CAGR does not take into account the volatility of the investment, which can have a significant impact on its overall performance.
