The Compound Annual Growth Rate (CAGR) refers to rate which shows annual growth of an investment over a specific time interval. It is assumed that the value of investment compounded during that period of time.
Unlike absolute return, CAGR takes into account the time value of money. Due to this it is able to reflect the true returns that an investment generated over a year.
You can find out CAGR of an investment by dividing the beginning value by the ending value, raise to the power of one divided by number of years and subtracting one from the result.
CAGR can be calculated by using a simple formula i.e.
CAGR = [(Ending value/Beginning Value)^(1/n)]-1
n = number of years
When you have been provided with the value at the end and the beginning along with the number of years, you can apply this formula to know your rate of return on investment.
Suppose the value of an investment in the beginning was Rs 100. By the end of the year, it grew to Rs 150. The CAGR of the investment is 50%.
How to use CAGR calculator?
You can use CAGR calculator for a variety of purposes.
All you need is to enter the type of rate of return, beginning and ending value of investment and number of years of investment. The annual rate of return is displayed at the bottom in green colour.
How to apply CAGR in matters of investment?
CAGR is an easy-to-use tool to analyse your investment decisions. It finds application in the following scenarios:
You bought specific units of an equity fund in the beginning of the year. At the end of the year you notice an increase in the fund value. Now you want to know what is the rate of return on your investment.
You want to know at what rate your money needs to grow so as to accumulate a particular sum of money in future.
Consider an equity fund whose 3/5/10 year returns are 30%, 18% and 12% respectively. You want to know average rate at which the fund grew every year.
Compare CAGR of an investment with your expected rate of return to check its suitability. Invest only if CAGR is equal to/higher than expected rate of return.
Using CAGR, you can compare two mutual fund schemes in the same fund category. Choose the scheme which has a higher CAGR.
CAGR of a mutual fund scheme can be compared with the benchmark return to ascertain underperformance/ outperformance.
Limitations of CAGR Calculator
Even though CAGR is a useful concept, it suffers from several limitations. A lack of awareness of these limitations might lead to wrong investment decisions.
Some of the limitations are as follows:
The concept of CAGR consider only the beginning and ending values. It ignores the volatility aspect. It assumes that an investment grew at a constant rate every year which might not be true at all times.
CAGR is suitable when you do a lump sum investment. On the contrary, it is highly irrelevant in case of SIP investments. In SIP, you invest a fixed/variable amount at regular intervals. But CAGR doesn’t give regard to values in between the starting and ending dates.
CAGR doesn’t account for risk inherent in an investment. When it comes to equity investments, risk-adjusted returns are more important than CAGR. For this, you need to use better ratios like Sharpe Ratio.