CAGR is a simple metric used in the finance world for calculating the compounded returns of an investment on an annual basis over a period. Check out this post to know how it is calculated and what are the things you should keep in mind while calculating and analysing CAGR.
One of the biggest reasons why financial experts recommend people to start investing as earlier in life as possible is to benefit from the power of compounding. Compounding is when you start earning returns on the returns that have already been generated by your investment.
For instance, when you re-invest the interest you earn from a bank FD, the interest then starts earning interest along with your principal amount. This cycle continues every year, helping investors generate high returns in the longer run.
It is with the help of CAGR (Compound Annual Growth Rate) that the annual compounded returns of an investment are calculated. Let us understand what CAGR is, why is it important, and how it is calculated.
Before talking about how to calculate Compound Annual Growth Rate, let us first try to understand why this metric is so commonly used for gauging the performance of investments like mutual funds.
So, let us assume that you are investing Rs. 1 lakh in an equity mutual fund. This is how the fund might perform for over five years.
So, over five years, the initial investment amount of Rs. 1 lakh will turn into Rs. 1,45,000 as the overall returns stand at 45%. In other words, the investment earned returns at a rate of 9% per year.
But, when you only consider the average returns, it does not tell you the losses or negative returns that the fund might have delivered in any of those years. For instance, in the table above, you can see that the fund delivered negative returns in the 4th and 5th year.
So, while the average returns of 9% per year over five years might look good, you can see that the performance of the fun has deteriorated in the last two years.
CAGR, on the other hand, considers such losses, as well as the compounding, to help you understand the average annual returns a fund might be generating over five years.
The simplest way to calculate CAGR is to use an online CAGR calculator. But it is still crucial to understand how the calculation works.
To calculate CAGR, you will need-
BV- Beginning Value of Investment
EV- Ending Value of Investment
CAGR formula is as follows-
CAGR = 〖(EV/BV)〗^(1/n) - 1
Let us use the same example as above to demonstrate the working of this formula. So, the CAGR over 5 years would be equal to-
= 〖(1,45,000/1,00,000)〗^(1/5) – 1
= 7.71% This means that over five years, the returns from this mutual fund grew at the rate of 7.71% every year.
CAGR is commonly used for estimating returns in investment options where the value of investment fluctuates regularly. For instance, in the case of mutual funds, you can use the CAGR formula for calculating this metric and gauging the performance of a particular fund against a benchmark or other funds of the same category.
Just like mutual funds, benchmarks such as Sensex, Nifty, Nifty Next 50, etc. also have their CAGR. Even companies have their CAGRs, which is used by investors for tracking their performance.
While CAGR makes it easier for the investors to determine whether or not the risk-taking premium of an investment option is high, there are a few points one should remember. For instance-
CAGR is only an estimate and not the actual rate of return
When comparing CAGR of two funds, fund against an index, etc. make sure that you consider the same investment duration
CAGR does not consider the volatility or the profitability arising from inflows and outflows in an investment
An online compound growth calculator can be a better choice over manual calculations as online tools are not prone to manual errors
CAGR should only be used with regards to lump-sum investments and not for investment options like SIP where a smaller amount is regularly invested as CAGR only considers the beginning and ending value
CAGR is mostly calculated on longer timeframes but not for durations more than ten years
Investment decisions should never be taken based on CAGR alone as the metric has its limitations
CAGR is one of the most reliable ways to analyse the returns potential of an investment. By comparing the CAGR of investments that have similar characteristics and volatility over a similar duration, you can also select an investment option that best suits your investment objective.
Now that you know how to calculate CAGR, along with the tips on how to use it, start checking the compounded annual growth of the different investment options you are considering to pick the best.