## What Is Compound Annual Growth Rate (CAGR)?

**REtipster does not provide tax, investment, or financial advice.** Always seek the help of a licensed financial professional before taking action.

## Compound Annual Growth Rate in Closer Detail

The compound annual growth rate measures how much an investment or company has grown each year over a given period. CAGR accounts for the effect of compounding, which means that profits gained at the end of each year are assumed to be reinvested and no deductions have been made.

By calculating how the value of an investment has changed over a specific period, investors can determine its overall performance and decide whether it is worth buying into.

Some years may have experienced more growth than others, but the CAGR “smooths” out the overall rate when looking at the given investment timeframe. This is one reason the CAGR is also known as the “smoothed” rate of return.

Note that the CAGR does not give actual return rates. Rather, it provides a representational figure that describes how much the investment value would have changed if it had maintained the same growth rate every year[1].

## How Does the CAGR Work?

Financial markets are inherently volatile, making it difficult for investors to know which investments to secure. While there is no foolproof way to predict how any given market will play out, some indicators can provide invaluable insight into opportunities that might be worth exploring.

The CAGR is one such metric. It is a decision-making tool that investors can use to find worthwhile investments based on their performance over several years.

##### How to Calculate CAGR

To calculate CAGR, take an asset’s first and last values over a given period. The aim is to evaluate its performance or changes in value within that specific timeframe.

The CAGR formula assumes that any value earned—interests, dividends, etc.—is reinvested and therefore compounded into the investment.

It is expressed as:

[EV / BV]1/n – 1

Where:

*EV*= Ending value*BV*= Beginning value*n*= Number of years being evaluated

Here is a simple example. Suppose the value of an investment has grown from $1,000 to $1,800 over the last five years. After plugging in these values, the CAGR formula would look like this:

CAGR = (1800/1000) ⅕ – 1

= (1.8)0.2 – 1

= 1.12475 – 1

= 0.12475

CAGR = 12.475%

This means that the investment has grown by 12.475% every year during the selected five-year period.

Trying to do these calculations on a sheet of paper can be challenging, so one can use online calculators as an alternative. Another option is to use the XIRR function[2] in Microsoft Excel. This can save a lot of time, especially if the investor is calculating the CAGR for multiple investments.

## Is the CAGR a Good Metric?

Because it considers the starting and ending values of an investment over a specified period, CAGR is a good metric for measuring yearly growth rate and overall performance. It is also a great tool for calculating historical returns, especially for securities that have no publicly available data, such as physical assets or property[3].

The CAGR can measure and compare the performance of different investment options since it assumes a constant growth rate across the period. This, in turn, helps smoothen out the returns over the said period. Additionally, CAGR calculations are useful in projecting future returns from the investment.

The CAGR is also a great way to better understand an organization’s financial strength or weakness over a particular period. Suppose a company’s CAGR shows a steady decline over an eight-year interval. In that case, it may be an indication that the business is struggling with issues that are affecting its profitability.

##### Drawbacks of the CAGR

The CAGR is not without its limitations for all the invaluable insights that it provides.

For one, it does not account for all the cash inflows and outflows that happen during the investment tenure, only the beginning and ending values. If an investor adds or withdraws funds from the investment during the period being measured, it is not included in the results from the CAGR.

For example, consider an investor that utilized dollar-cost averaging[4] and consistently injected funds into their portfolio for the last five years. If the CAGR takes these injections into account, it will calculate the funds as part of the annual growth rate. This will result in an inflated, and thus inaccurate, CAGR value.

Other drawbacks of the CAGR include:

###### It Does Not Account for Investment Risk

The CAGR is based on past performance so it is not a good measure for volatility. As every true investor knows, there is no investment without risk, but the CAGR does not account for the varying degrees of risk that all investments are exposed to every day.

However, Sharpe’s Ratio[5] can offer a workaround to calculate risk-adjusted CAGR. This method involves establishing a risk-free rate, usually based on the yield on Treasury bonds[6] or other risk-free investments, and then measuring the investment’s standard deviation. The wider the standard deviation, the lower the value of the risk-adjusted CAGR.

###### It Neglects the History of Highs and Lows

Because the CAGR represents a smoothed value, it cannot show the highs and lows of an investment over the selected period. Growth is assumed to be constant, which is hardly ever true in the financial markets.

###### Its Scope Can Be Limited

Data from a CAGR result can be limited because the metric only measures performance over a specific timeframe. Any other changes outside that period are not considered. This dearth of information and context may skew the interpretation of the CAGR.

## What Is Considered a Good CAGR?

There is no standard for what constitutes a good CAGR because “good” depends on the context. In other words, a good CAGR is only in reference to an established norm.

For instance, if an investment portfolio has a CAGR of 15% whereas the market has had an average CAGR of 10%, then the results are deemed impressive. If using CAGR to measure company growth, the result is compared with that of other companies in the same peer group.

Another approach is to compare the CAGR of an investment against another metric, such as interest rates of saving accounts. If it is higher, the investment is appreciating more than it would have if left in a savings account.

## Takeaways

- The compound annual growth rate or CAGR is a metric that measures an investment’s average annual growth rate over a specific duration. This figure assumes that any value earned during that period is reinvested and has therefore compounded at the end of the selected duration.
- It is a useful method for determining the performance of an investment or organization. Investors also use the CAGR to project expected future returns based on data from historical performance and help them make informed decisions regarding what investment opportunities are worth exploring.
- The CAGR formula is calculated using the ending value (EV), beginning value (BV), and the number of years being evaluated (n). There is no universally accepted “good” CAGR as it depends on a benchmark.

## Sources

- Chaluvadi, S. (2022). Compound Annual Growth Rate. Scripbox. Retrieved from https://scripbox.com/mf/cagr-compound-annual-growth-rate/
- Microsoft Support. (n.d.) XIRR Function. Retrieved from https://support.microsoft.com/en-us/office/xirr-function-de1242ec-6477-445b-b11b-a303ad9adc9d
- Kavanagh, R. (2021).
*What is compound annual growth rate?*Business Insider. Retrieved from https://www.businessinsider.com/personal-finance/cagr - FINRA. (n.d.) Three Things To Know About Dollar-Cost Averaging. Retrieved from https://www.finra.org/investors/insights/three-things-know-about-dollar-cost-averaging
- Corporate Finance Institute. (n.d.) Sharpe Ratio — The golden industry standard for risk-adjusted return. Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/finance/sharpe-ratio-definition-formula/
- Bloomberg. (n.d.) United States Rates & Bonds. Retrieved from https://www.bloomberg.com/markets/rates-bonds/government-bonds/us