The compound annual growth rate (CAGR) is one of the most accurate techniques to predict the value that investors will get as a return after their investment period has been completed.
(CAGR) is a measure of an investment’s growth over successive periods during its lifetime.
That is, the projected rate of return on investment from its initial balance to its final balance if profits are reinvested at the end of each year.
A simple mathematical formula can be used to compute the CAGR.
(Vfinal / Vbegin)1/t – 1 = CAGR
Where Vbegin denotes the starting value, Vfinal denotes the ending value, and t is the period in years.
What Should You Be Aware of When It Comes To CAGR?
There are a few things you should know about CAGR if you’re an investor:
- The CAGR and the year-on-year growth rate are not the same.
- CAGR does not account for sales that occurred from the first to the last year. It’s not uncommon for all of a person’s growth to occur in the first or last year.
- There’s a chance that two investments have the same CAGR. This is feasible since one’s growth is faster in the first year while the other’s growth is faster in the last year.
- CAGRs with investment durations ranging from three to seven years are commonly used. If the period is longer than ten years, the CAGR may obscure the sub-trends in between.
How to calculate the compound annual growth?
Many investors look at their investment‘s performance in terms of absolute returns. However, it fails to take into account the time worth of money. CAGR takes into account the time period in which you invested, giving you a more accurate and realistic rate of return on your money.
Furthermore, it is a fantastic approach to determine the asset’s variations over a specific period. This makes it simple to assess its performance and determine how well a particular investment performed in comparison to its pricing.
When it comes to determining compound annual growth rate, these three processes must be taken into account. All three numbers should be memorized:
- Investment value at the start of the year.
- Investment value at the end of the year.
- The duration of an investment
CAGR’s Advantages and Disadvantages
The most dependable criterion for estimating the growth of your investment is the compound annual growth rate (CAGR). It’s because, unlike the absolute rate of return, it considers compounding, resulting in a more precise estimate. However, this device has several advantages and disadvantages.
Advantages of Compound annual growth rate
- A compound annual growth rate allows investors to compare and assess historical investment performance over various time frames. This comparison aids in determining the relative performance of your investments.
- It’s also useful for comparing one stock’s performance to that of another.
- CAGR aids in determining the projected returns on your investments.
- It enables you to give risk-free instruments for calculating a certain investment’s returns.
Disadvantages of Compound annual growth rate
- The compound annual growth rate (CAGR) provides no information regarding the risk of an investment. It’s nothing more than a reflection of prior performance. It doesn’t take into consideration the different levels of risk that all investments face. Other methods, such as Sharpe’s Ratio and Treynor’s Ratios, can be used to estimate an investment’s risk-return benefit because they account for dangers that CAGR does not.
- CAGR is a “smoothed” value, which means it does not reveal the highs and lows that investment has experienced. Even if this isn’t always the case, growth is supposed to be constant throughout the period.
- (CAGR) cannot forecast how an investment will perform in the future. You can use historical performance to predict whether or not an investment will continue to grow in the same manner. However, no matter how consistent development has been in the past, it is by no means a guarantee. Indeed, according to Garza, the shorter the period chosen in your investigation, the less probable the projected CAGR performance will be reproduced.
- When it comes to CAGR, data representation can be constrained because you’re only looking at performance over a given period. The interpretation of CAGR can be skewed by a lack of context. For example, the CAGR will appear excessively high if you’re looking at a stock that was heavily hit during a recession and showed strong growth in the years after a substantial loss. As the company matures, the rate of growth will most certainly slow.
Now let’s have a look at the compound monthly growth rate
What is CMGR (Compound Monthly Growth Rate)?
The compounding monthly growth rate (CMGR) is the average monthly growth rate over a longer period, often 6 to 18 months.
The following formula is used to calculate CMGR:
- CMGR = Last Month Measurement/First Month Measurement 1/[Last Month – First Month] – 1 CMGR = Last Month Measurement/First Month Measurement 1/[Last Month – First Month] – 1 CMGR = Last Month Measure
- Let’s imagine you’re a mobile marketer that wants to track the growth of total users, MOM, over a year since your app was released. Instead of calculating each month separately, you’d utilize CMGR to determine an average.
- For example, you only had 100 active users at the end of month one, but at the end of month 12, you had 5,000. Here’s how to figure out what your CMGR is in your situation:
- CMGR = 5,000/100 CMGR = 5,000/100 CMGR = 5,000/ 42.71 percent = 1/[12 – 1] – 1
The compound annual growth rate (CAGR) is a very useful metric for calculating the rate of return on investment. It can be used to evaluate past performance or anticipate future investment returns. Keep in mind, though, that CAGR is better for lump-sum investments. Monthly investments are omitted in Systematic Investment Plans (SIPs) since the algorithm only looks at the beginning and end amounts. Overall, the CAGR calculator is a useful tool for determining the return on your assets.
Although the compound annual growth rate (CAGR) is a valuable tool for analyzing investment opportunities, it does not tell the whole story. CAGRs from similar time periods can be compared to compare investment options. Investors, on the other hand, must evaluate the proportional risk of their investments. As a result, an alternative metric, such as the standard deviation, must be used.