Definition
The acronym CAGR stands for Compound annual growth rate, and it is an average measure of how an investment has performed over a long period. It is generally used when we have invested a fixed amount in some financial product for more than a year, and its yearly rate of return is not fixed.
Consider a savings account in which the account holder will be getting \( \textbf{3%} \) returns annually. For this scenario, CAGR will be the same as RoR, i.e. \( \textbf{3%} \), thus CAGR is not used for this type of financial product. Consider a financial product where the annual rate of returns is not fixed, like mutual funds whose returns are based on stock markets. For these types of products, CAGR is used, considering there is only a one-time investment.
Uses
- To compare the performance of businesses and forecast their future growth based upon their historical cashflow details.
- To calculate the average growth (percentage) of a single investment
- Comparing financial products like mutual funds by calculating their past t years' CAGR.
Calculation
CAGR is a formula that calculates how the value of an investment has changed throughout a specific time period, assuming all earnings have been reinvested and no deductions have been made.
Example 1
Suppose you invested ₹9,000 on 31-Dec-2019 and the value of the investment has grown to ₹ 13,000 on 31-Dec-2022, then CAGR on investment is \( \textbf{13%} \).
| Date | Year | Value of investment |
|---|---|---|
| 31-Dec-2020 | 1 | ₹10,100 |
| 31-Dec-2021 | 2 | ₹11,900 |
| 31-Dec-2022 | 3 | ₹13,000 |
Using formula,
You can also use our CAGR calculator for verification.
Example 2
Consider Year 1 and Year 2 of a sample investment I of ₹2,000 in a mutual fund M. At the end of the first year i.e. Year 1, the portfolio value dropped from ₹2,000 to ₹1500 for a return of \( \textbf{-25%} [ (1500 - 2000) / 2000 ]\). By the end of the second year i.e. Year 2, the portfolio value rose by \( \textbf{+33%} [ (2000 - 1500) / 1500 ] \).
When we take an average of returns from the first and second year over two years, then the average return turns out to be \(\textbf{4%} [(-25 + 33) / 2]\). But this isn't what happened. Mutual fund M began with ₹2,000 and ended with ₹2,000, which means investment I profited nothing over 2 years.
This depicts why CAGR turns out to be a better measure of accurate return over time.
CAGR vs Absolute return (RoR)
The major difference between the two is that RoR doesn't consider the time it took to get to the final value of the investment, thus RoR ignores the effect of compounding and may overestimate growth on investment.
CAGR calculates the rate at which the investment must have grown every year to get to the final value of the investment, thus taking the compounding factor into consideration.
CAGR vs IRR
Just like CAGR, IRR (Internal Rate of Return) also takes the time into consideration. But CAGR can only be used when there is only a single cash inflow (the initial investment) and only one cash outflow (the final amount of investment). In contrast, IRR can have multiple cash inflows and outflows.
CAGR vs XIRR
IRR and XIRR (Extended Internal Rate of Return) are mostly same as both are used when we have multiple cashflows in our portfolio, whereas CAGR can only be used with single cash inflow and cash outflow. XIRR is also called adjusted CAGR.