Compound Annual Growth Rate (CAGR)

/
/
/
709 Views
Compound Annual Growth Rate

What is CAGR? 

The CAGR is the geometrical way to find the amount of return you are receiving from an investment which weakens the effects of periodic returns which make arithmetical calculations useless. This way is more representational than exact, however this is a good way to estimate your investment returns and have a general idea if your investment is going to continue to be worth your time and money. Any and all investments are profit driven and determining investment viability in very important.

CAGR’s Other Uses

CAGR can also be used to determine if your investments marketing strategy is working or not by measuring the average customer satisfaction rate throughout the years. Even if your investment is generating good profits it can be helpful to project if those profits are going to increase or decrease; which will help you decide if you are going to maintain your investments or adjust them. CAGR provides you with a much broader analysis of your investments than any other method. You can also use it to compare other investments to see which ones are working the best for you and which ones you may want to withdraw from.

Limitations

As with any projection, CAGR is not perfect and is limited in three ways. These limitations do not prevent your calculation from being accurate but instead help to remind you that investments can change at any time regardless of how profitable they have been in the past. Using other projection methods in conjunction with CAGR can help you lessen these limitations.

The first limitation is that CAGR relies purely on historical data and cannot make predictions. The calculation will show you what has happened up to the point you calculate it. However, CAGR will not take into account the possibility of a market crash the following day or sudden economic issue. That may arise.

A second limitation is that when you have a fund’s manager they may not always be exact. Fund managers want to keep your investments and may creatively word the results of the CAGR to benefit them. For example if they tell you that your CAGR says that your last year awarded you a 35% increase compared to the past 4 years then you would more than likely consider your investment good. If you calculate the entire 5 years though you may see that your profit was in fact a mere 12% of your initial investment. This deception may keep your business for the fund manager but if you delve deeper to find out the full results of a CAGR then you may actually decide to pull your investment now, while it is still profitable.

The third limitation is that CAGR does not account for fluctuations in your investments value. Instead it calculates everything in a steady flow throughout the year. This does not allow you to know if there was a massive drop or increase at any point of the year. This is a good example of why you should not fully rely on your CAGR calculation but instead use it in conjunction with a broad range of calculations and investment tools to determine the final viability of your investment.

Formulas That Work with CAGR

When you use CAGR, you cannot rely purely on the resulting figures. It is best to incorporate other formulas that, in conjunction with CAGR, can help you to come to a more accurate result of your investment. These formulas predict the factors that CAGR cannot. This will make up for the limitations that come with CAGR.

To get around the first limitation you can use the Future Value Formula to determine what your investment may be worth in the future. This formula is similar to the CAGR and all you have to do is plug in the data and find your result. To find this you must take the present value of your investment and multiply it by one plus the periodic interest rate. Once you have done that you must take the result to the power of the number of periods. The written out formula is PV*(1+i)^t. The resulting value is the Future Value of your investment.

Dealing with the second limitation is simple. If you have a fund manager and are going to meet with them to go over your investments, it is always best to perform your own CAGR calculations so that you know if they are manipulating the numbers. As we said earlier, many fund managers will do this to try to keep your investments even if they are not doing as well as others.

Finally, CAGR cannot account for fluctuations. The remedy for this is to monitor your investments more closely, and compare them month to month. Using Benchmarks can simplify comparisons and tell you if your investment is providing results similar to other investments. When using Benchmarks you have to compare your investment to the correct type of other investments. For example, if you compare using the S&P 500, you are comparing to big businesses; but if you are comparing to the Russell 2000, you are comparing to small businesses.

When you are using all of these methods, you are able to get a more well-rounded idea of how your investment is faring. No investment has steady, one hundred percent growth for ever, so steady tracking of your investment will help you to decide if it is still right for you or if you may want to consider pulling your investment money and moving it somewhere else.

CAGR Calculations

CAGR can be calculated by using the CAGR calculation. The calculation is much simpler than most would think. First you must choose the length of time you are looking to measure using the calculation. In this case, let’s say that is five years. Take the last investment value and divide it by the original investment. So, take your total from year five and divide it by the investment you made year one. Raise the result to the power of one divided by the total amount of years and finally subtract one from the resulting value.

Calculation Results

Once you have completed all of these steps you have found the CAGR of those five years and you are one step closer to deciding if your investment is worth your time and money. This calculation can also be used to compare multiple different stages of your investments, which will help you to determine which stage was the most beneficial to you. Different stages can be any interval of years that you want, but remember that both stages have to calculated with the same intervals or your resulting comparison will be inaccurate.

CAGR Calculators

An easier way to calculate your CAGR is to use a CAGR calculator. Most investment companies have these calculators available on their websites and there is even a way to use Microsoft Excel to calculate your CAGR. These calculators can make this process much faster. The online calculators are typically simple to use by just plugging in the same information used when you perform the calculation yourself. It is always recommended to perform your own calculations as well to ensure that the CAGR calculator you are using is working correctly.

CAGR and Microsoft Excel

The most popular data input and management software is Microsoft Excel, which allows you to plug information into cells and use mathematical calculations to determine values just like using a calculator. The process to use Microsoft Excel to calculate your CAGR is simple. First collect the same data that you would need to calculate yourself or with a calculator. Input the information into a row of blank cells. In this case we are using row “A”. Select a blank cell nearby and input the equation ((A11/A2)^(1/10-1))-1, and then press enter. You will see the CAGR appear in the blank cell. This resulting number will also change if you alter any of the cells that are included in the equation.

If you want to compare multiple different CAGR’s, all you need to do is input another set of values into a new row and repeat the formula in another nearby blank cell. Once again, it is still recommended that you perform the CAGR equation again yourself, so that you can make sure you did not input the formula incorrectly.

Conclusion

CAGR can be one of the best tools to compliment your investment strategy when used properly. In the end you have to remember that your investment is your future and CAGR can help you determine if that is the future for you.

Related Read

Breakeven point

Leave a Comment

Your email address will not be published.

This div height required for enabling the sticky sidebar