Compound Annual Growth Rate (CAGR): The Eighth Wonder

2 Jan 2021  Read 264 Views

“Compound interest is the eighth wonder of the world. He who understands it earns it and he who doesn’t pay it.” – Albert Einstein.

Knowingly or unknowingly, even our parents used the concept of compound interest. Since the last decade, people found post office savings beneficial and profitable the reason behind such a feeling was compound interest. 

The application of Compound Interest expands to the entire stream of financial management and investment.

After the immense growth in the stock market participation, investors are now keen to know more about the finance and the working of the stock market.

CAGR is one of the widely used terms in the stock market, and understanding it is crucial.

So, let’s dive into the topic and understand the CAGR.

What is CAGR?

CAGR stands for “Compound Annual Growth Rate”.

Typically, CAGR is the rate of return on investment from the beginning (acquisition) to end (sale), assuming all the profits reinvested. 

CAGR overrides the significance to be placed upon annual return. The reason for this, higher return in a year could be due to an exceptional or extraordinary gain, but a consistent return is what an investor should rely upon. CAGR shows the average returns that investment would earn annually, over the period of investment.

CAGR is used to measure and compare the past performance of investments or speculate their future returns. It gives the most accurate and reliable results to calculate the returns of assets, portfolio, and other securities whose Value can rise or fall over time.

In layman language, CAGR represents how much a person’s investment has grown on an average in a year.

CAGR is calculated in terms of percentage.

For example, TCS experienced a market capitalisation compound growth rate at 31.5%, while earnings grew at 26.7 CAGR in the last five years. This represents that average market capitalisation grew at the rate of 31.5% yearly for the last five years; on the other hand, earnings grew at 26.7%.

Calculation of CAGR

Majority of investors rely on absolute returns for analysing the performance of the investment portfolio. However, they forget to consider the time value of money while calculating the returns.

CAGR considers the time for which the investors have stayed invested and provide the approximate rate at which investments will grow if there isn’t any volatility.

It is most often used in comparing the past performance of the investment or their expected future returns. 

Let’s walk down to understand the CAGR formula:

One must know these three numbers to calculate the CAGR:

a. The investment made in the starting year (the first year of investment)

b. End Value of investment in the final year

c. Period of the investment

The formula for CAGR is

CAGR = (End Value/Beginning Value)^(1/Years) - 1 

For example, you bought a stock at Rs. 100 in 2016. In 2017, the value of the stock increased to Rs. 125 and further to Rs. 150 in 2018. Hence, the total appreciation was 50% between 2016 to 2018. Now, if you want to know the growth rate over the years annually, use CAGR. If you put these values in the above formula, then the CAGR between 2016 to 2018 will be 22.47.

With this formula, you can easily calculate the performance of the investment in due course of time. This is the best way to find how investment has been as compared to price.

CAGR for investors

  • The CAGR is not an indicator of sales that occurred from the initial year to the last year. In some cases, maybe whole growth is focused in the initial year or at the end of the year.
  • Sometimes, two investments may reflect the same CAGR, while one being more profitable than the other. This could happen because the growth was faster in the initial year for one, while the growth was faster in the last year for the other one.
  • Investors usually check CAGR for investment periods ranging from three to seven years. If the tenure is more than, seven years, then the CAGR may conceal the sub-trends in between the years.
  • For long term investment, comparing CAGR is important to understand whether the investment in the company is value investment or not. 

Advantages of CAGR

CAGR is one of the most popular variables used to decide the profitability of an investment as it shows the average performance of the investment over a while. Short term CAGR contains all fundamental factors concerning the operation of securities. 

CAGR for an extended time sort out all short-term fluctuation, as the security recovers shortly from such market shocks, assisting individuals in concluding the true potential of the companies.

Limitation of CAGR

Does not reflect market volatility

CAGR shows an average growth of a stock given no external influence was present. It does not consider the important factor of stock market fluctuations, which has an important effect on the stock performance of listed companies. CAGR neglects all variations in the annual return rate of investment while studying an average of the same. 

For example, a stock market instrument can have a return of 25% during the first period of investment, 10% in the second year, 16% in the third year, and 15% in the fourth year. 

S. No.

Year 

Rate of return YoY (%)

1.

I

25

2.

II

10

3.

III

16

4.

IV

15

The return CAGR of the security = (25+10+16+15)/4 

                                                           = 16.5% 

This Value represents that security has experienced an average CAGR growth at 16.5% annually for four years. But as per the data, the security experienced 25% growth in the initial year, from positive market fluctuation. In the second year, the growth of the stock decreased to 9% due to any adverse event in an economy, or the capital sector.

Not ideal for risk assessment 

Since CAGR does not imitate the volatility of a security trade in the stock market, investors might not get a clear idea concerning the performance of the stock in the event of huge volatility. By just comparing the CAGR of two companies, we can’t find the behavioural pattern of the stock because it neglects the short term volatility. Other technical analysis tools should be used hand in hand to speculate accurate predictions regarding the performance of a stock market to ensure investment in profitable schemes. 

                                        

Conclusion

The crux of the topic is that CAGR is more reliable in tracking the performance of an investment over a while because the annual rate does not consider compounding leading to overestimation. 

In the end, it is useful to understand the concept of CAGR by investors to understand the performance of their portfolio.

About the Author: Harshit Roy | 14 Post(s)

Harshit Roy is a BMS student at St. Xavier's College, Kolkata majoring in finance. He is bibliophile in nature, and quite eager to learn and read about new things in life.

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