What is CAGR (Compound Annual Growth Rate) & How to Calculate it?
The CAGR full form in the stock market is the compound annual growth rate. It is one of the most commonly used investment metrics to evaluate an investment’s performance over a period of time. It allows investors to understand their investments’ growth rates and make informed decisions.
This blog will delve into the CAGR meaning in share market, covering how to calculate CAGR for SIP and Lumpsum, limitations, and, most importantly, its significance in investment analysis. So, rest assured that by the end of this journey, you will have a thorough understanding of CAGR.
What is CAGR in SIP or Lumpsum Investments?
CAGR, or compound annual growth rate, is a widely used return metric. Unlike absolute return, which only considers the point-to-point return from an investment, CAGR records the yearly return generated by an investment, considering the time required to create it.
The compound annual growth rate is preferred over the other metrics because it provides the average yearly return achieved by an investment based on the initial invested amount, the final value of the investment, and the time period elapsed, allowing returns to be compared across different asset classes. Let us now learn how to calculate compound annual growth rate or CAGR.
What is CAGR in smallcases?
The compound annual growth rate plays a vital role in:
- Comparing smallcases
- Making a final investment decision
Our platform calculates the compound annual growth rate based on live data. You can see the CAGR and the time label while going through a smallcase. This not only helps you compare the smallcases but also helps you understand how the returns of your smallcases have been calculated.
The compound annual growth rate will show absolute performance for smallcases that have been live on the platform for less than a year. Whereas, smallcases that have been on the platform for more than a year will show calculations using the compound annual growth rate formula.
How to Calculate CAGR?
The compound annual growth rate is calculated by taking the ending value of an investment, dividing it by the beginning value, taking the nth root of that number (where n is the number of years), and then subtracting 1 from that result.
The Formula for CAGR Calculation
The CAGR calculation formula for the compound annual growth rate is as follows:
CAGR =(Ending balance/beginning balance)^1/n – 1
Ending balance = Value of the investment at the end of the investment period
Beginning balance = Value of the investment at the beginning of the investment period
N = Number of years you have invested
CAGR Example
Suppose Sarah invested Rs. 5,000 in a mutual fund in 2018. The value of her investment grew to Rs. 6,500 by 2021. Let’s calculate the Compound Annual Growth Rate (CAGR) for Sarah’s investment.
- Beginning balance (2018): Rs. 5,000
- Ending balance (2021): Rs. 6,500
- Investment period: 2021 – 2018 = 3 years
CAGR =(Ending balance/beginning balance)^1/n – 1
Therefore, CAGR = (6500/5500)^1/3 – 1
The resulting CAGR for Sarah’s investment is approximately 9.1%..
How to Calculate CAGR in Excel?
Unfortunately, there is no straightforward compound annual growth rate formula in Excel. Still, you can calculate it by using any of the below-mentioned functions:
- RRI function
- IRR function
- RATE function
- POWER function
The following screenshot depicts an Excel calculation of CAGR using the RRI function:
How to Interpret CAGR?
CAGR signifies investment growth over a specific period, representing the average return earned after that duration. It factors in the investment period, calculating returns with minimal volatility.
- Determining a Good CAGR: A specific percentage for a good CAGR in stock market equity investments varies but should ideally surpass savings account interest rates.
- Large-cap Investments: Historically, large, stable companies have provided 8% to 12% returns for long-term investors.
- Small and Mid-cap Investments: These offer higher potential returns but have higher volatility, historically exceeding 15% for risk-aware investors.
What is CAGR in Stocks?
The CAGR of total stock market returns illustrates the average growth rate. Before making stock market investments, it’s essential to compare expected returns with CAGR to assess profitability.
CAGR aids in long-term analysis, reducing unsystematic risk linked to economic fluctuations. Smoothing short-term variations offers insights into a company’s structural performance.
Comparing compound annual growth rates for long-term investments is vital for identifying value investments. Value stocks typically exhibit consistently high CAGRs, sometimes leading to significant long-term capital gains.
Uses of CAGR
CAGR serves various purposes:
- Comparing Investment Performance: It standardises investment performance assessment, allowing equal evaluation based on average annual growth rather than absolute numbers.
- Long-Term Planning: Compound annual growth rate aids long-term investment planning by estimating potential growth, helping investors project future values and make informed decisions.
- Evaluating Investment Risk: CAGR assesses investment risk. A consistently positive compound annual growth rate over time signals stable, reliable growth attractive to risk-averse investors.
- Assessing Performance: Investors use compound annual growth rates and annualised yield to assess historical performance. Comparison with benchmarks helps gauge investment strategy effectiveness and identify areas for improvement.
Advantages of Compound Annual Growth Rate
One of the most widely used metrics to gauge an investment’s profitability is its compound annual growth rate, which shows how well the endeavour has performed on average over time. The advantages of compound annual growth rate are as follows:
- CAGR considers all underlying variables: The short-term compound annual growth rate considers all underlying variables, such as market conditions, that affect the performance of such investments.
- CAGR rules out short-term deviations: When looking at compound annual growth rate over a long period of time, all short-term deviations are ruled out because the market swiftly bounces back from shocks. This allows people to assess the genuine potential of the various companies.
Factors to Consider When Using CAGR
Several factors should be considered when using the compound annual growth rate to analyse investments. Some of the important factors to keep in mind are:
- Time Period: The period of investment considered for calculating CAGR is crucial. A longer investment horizon provides a better view of the returns, whereas a shorter period may be misleading. It is important to use a consistent time period when comparing investments.
- Market Fluctuations: Market fluctuations can significantly impact the compound annual growth rate. An investment with a higher return over a shorter period may not necessarily provide the same returns over a longer period. It is important to consider market trends and volatility while analysing investments.
- Risk: CAGR does not consider the risk associated with the investment. A higher compound annual growth rate may not necessarily be a better investment if it is accompanied by higher risk. Therefore, it is important to analyse the risk associated with the investment and CAGR.
- Currency Fluctuations: If the investment is made in a foreign currency, currency fluctuations can impact the CAGR. Therefore, it is important to consider currency fluctuations while analysing the returns.
- Taxes and Fees: Taxes and fees can significantly reduce investment returns. Therefore, it is important to consider their impact on CAGR while analysing investments.
Limitations of Compound Annual Growth Rate
The compound growth rate is a helpful tool for analyzing investment performance, but its use has limitations. One limitation is that it assumes a constant growth rate over the analysed period. Which may not be accurate in real-life scenarios where market conditions and other factors can cause fluctuations in growth rates.
Furthermore, the compound annual growth rate may not be the best metric for comparing investments with different risk levels, as it does not consider the variability of returns. For example, a high-risk investment may have a higher CAGR than a low-risk investment, but the latter may provide more consistent returns over time.
What is the NIFTY CAGR?
Nifty CAGR refers to the compound annual growth rate of the National Stock Exchange (NSE) Nifty index. The Nifty index represents the performance of the top 50 companies listed on the NSE and is considered a benchmark index for the Indian equity market.
The compound annual growth rate of the Nifty is calculated by taking the annual percentage change in the index level over a specified period of time and compounding those returns over that period. It is a useful measure for evaluating the long-term returns of an investment in the Nifty index. A higher compound annual growth rate indicates better long-term performance of the Nifty, while a lower CAGR indicates lower performance.
IRR vs CAGR
The following table is a comparative analysis of CAGR vs IRR:
| Aspects of Comparison | CAGR | IRR |
| Calculation Method | Straightforward and can be done manually. | More complex and often requires financial tools like calculators, Excel, or portfolio accounting systems. |
| Purpose | Measures investment return over a specific period. | Evaluates investment or project performance, especially when multiple cash flows are involved. |
| Applicability | Suitable for simpler investments or periods with consistent growth. | Best for complex investments with varying cash flows. |
| Flexibility | Less flexible, as it assumes a constant annual rate of return. | More flexible, accommodating varying rates of return. |
| Ease of Comprehension | Easier to understand straightforward scenarios. | May be challenging for those not well-versed in finance. |
| Suitable Calculation Tool | Easily calculated by hand. | Requires specialised financial tools. |
| Educational Resources | Useful for those learning about investments. | Valuable for those interested in advanced financial topics. |
XIRR vs CAGR
The following table charts the difference between XIRR and CAGR:
| Basis | XIRR | CAGR |
| Meaning | Calculates the rate of return based on both investments and cash flows. | Calculates the rate of return based only on the beginning and ending investment value. |
| Calculation | Calculates returns of irregular cash flows | Calculates returns of constant investments |
| Timing | Takes into account the timing of cash flows. | Does not consider the timing of cash flows. |
| Inclusion of Cash Flows | Requires all cash flows to be present. | Requires the initial and final investment amounts only. |
| Investment Type | Can handle investments with multiple inflows and outflows. | Only applicable to investments with a fixed investment amount. |
| Rate of Return | Considers the internal rate of return. | Considers the average annual growth rate. |
| Complexity | More complex calculation method. | Simple calculation method. |
| Accuracy | More accurate as it considers the timing and value of each cash flow. | Less accurate as it does not consider the timing and value of each cash flow. |
Read more about their differences in this article on XIRR vs CAGR.
To Wrap It Up…
The compound annual growth rate is an important metric for measuring your investments’ growth rate over time. It provides a standardised way to compare the performance of different investment options and makes it easier to make informed decisions about where to put your money.
However, it is important to consider the limitations of CAGR and use it in conjunction with other metrics and factors when making investment decisions. You can compare CAGRs on small cases to build a low-cost, diversified portfolio aligned with your expected returns.
Frequently Asked Questions About CAGR
A good CAGR for large companies in an industry ranges from 8% to 12%, whereas high-risk companies aim for a compound annual growth rate between 15% to 25%.
CAGR is a valuable tool for new investors to assess performance and find the best return mutual fund schemes. While a high CAGR for a mutual fund is promising, always align your investments with your financial goals and risk tolerance, before investing in any funds.
CAGR (Compound Annual Growth Rate) calculates a single growth rate for a specific period, considering compounding effects. In contrast, the annual return rate is a simple average of yearly growth rates without accounting for compounding.
A negative CAGR signifies losses instead of gains over time.
CAGR represents the average annual growth rate of an investment. A 10% compound annual growth rate means that each year, you earn 10% interest on your initial investment, which is then reinvested, and you earn an additional 10% return on the total amount.
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