What is compound annual growth rate (CAGR)?

What is compound annual growth rate (CAGR)?

Compound annual growth rate (CAGR) measures the average annual return of an investment over a period of time. CAGR can be used to calculate the return on assets that can increase and decrease in value over time.

It can calculate the return on individual assets or entire portfolios. The CAGR calculation provides a smoothed out rate of return for assets being measured on an annually compounded basis.

Why is CAGR useful?

CAGR provides the rate of return on investment on an annually compounded basis, so it has to be measured over more than 1 year. 

CAGR is a valuable way to measure how different investments have performed over time. It can be used to compare individual investments or portfolios against each other, a market index, or the returns of alternative investments such as bonds or savings accounts. When using CAGR to compare investment returns, it is vital that it is calculated over the same periods. 

One thing that CAGR does not consider is the riskiness of investments. Because interest rates are low, the CAGR on a savings account will also be low. However, the risk of losing money in a savings account is virtually nil. The CAGR of an ASX share that has performed well over the same period is likely to be much higher, but the risk of losing money is also higher. 

Returns on investments in ASX shares (and similar investments) are volatile, meaning they can vary widely over time. CAGR does not account for this volatility, instead providing a smoothed out rate of return. This can give the impression of steady growth in an investment when in fact, the underlying value of the investment may have varied significantly over the period being measured. 

How do you calculate CAGR? 

To calculate the CAGR of an asset or portfolio, you need the nth root of the total return on your investment, where n equals the number of years the investment has been held. 

The following formula is then used to calculate the CAGR of an investment:

 CAGR = (final value ÷ initial value)1÷n - 1

Final value = the value of the investment today.

Initial value = the value of the investment when you bought it.

n = time in years.

Let’s take a look at an example. Say you initially invested $1,000. After 1 year, your investment was worth $1,500. In year 2, the investment went backwards, ending the year at $1,200. By the end of year 3, the investment had increased in value to $2,000. 

For this example, the CAGR formula would be as follows: 

CAGR = ($2,000 ÷ $1,000)1÷3 - 1

This gives a CAGR of 25.9%. Note that the CAGR assumes a constant growth rate across the measured period, smoothing out volatile or inconsistent growth rates. This makes it easier to compare different investments or measure the performance of a specific investment. 

Why is CAGR an important metric for companies?

Where investment prices are volatile, arithmetic averages quickly become meaningless. The CAGR overcomes this issue, allowing for a meaningful calculation of growth rates over time.  

Of course, CAGR is a historical measure – it can only tell you about past performance, not how an investment will perform in the future. But that doesn’t mean it can’t play a role in evaluating potential investments. For example, say an ASX share has a 10-year CAGR of 15% – sounds like a pretty promising investment, right? But what if the 5-year CAGR of that same ASX share was 5%? Suddenly, the potential investment looks less promising, as the growth rate is slowing.

Calculating the CAGR of ASX shares can provide valuable insights into investment decisions. It allows you to see how an individual share has performed over a period of time. Sudden short term changes in share prices can cloud investment decisions. 

By utilising the CAGR, you can determine whether a particular ASX share has been growing steadily over a specific period of time. Because CAGR considers the effect of compounding, it can be especially useful in calculating the returns from investments. 

Of course, the CAGR is not the only metric that should be considered when evaluating investments. It is best used in combination with other metrics such as the P/E ratio, NPAT, and earnings per share

 

This article was last updated on 27 January 2022. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

 

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