Compound Annual Growth Rate (CAGR) Explained
CAGR (Compound Annual Growth Rate) is one of the most accurate ways to calculate and determine returns for anything that can rise or fall in value over time. It gives you a smoothed annual rate of growth that eliminates the noise of volatility.
CAGR vs Absolute Return
Many investors confuse Absolute Return with CAGR. Let's clarify with an example:
Scenario: You invest ₹1 Lakh in a stock. In 3 years, it grows to ₹1.5 Lakhs.
- Absolute Return: (Profit / Investment) * 100 = (50k / 1L) * 100 = 50%. This tells you the total gain.
- CAGR: Since the growth happened over 3 years, the annual growth rate is not simply 50/3 = 16.6%. Due to compounding, the CAGR is actually 14.47%. This tells you the effective yearly speed of growth.
The CAGR Formula
CAGR = (EV / BV)1/n - 1
Where:
EV = Ending Value
BV = Beginning Value
n = Number of Years
When to Use CAGR?
CAGR is the industry standard for:
- Comparing Investments: Comparing a Mutual Fund (volatile) with an FD (linear). CAGR puts them on the same "annualized" playing field.
- Business Growth: Measuring revenue or profit growth over a 5-year period.
- Portfolio Performance: Evaluating how your entire portfolio has performed over the long term.
Limitations of CAGR
While powerful, CAGR has one major blindness: it ignores volatility. It only cares about the Start Value and End Value. It does not tell you if the investment crashed by 50% in Year 2 and recovered in Year 3. Therefore, CAGR should always be used alongside risk metrics like Standard Deviation or Alpha.
How is CAGR different from XIRR?
CAGR is used for lump-sum investments where there is one inflow and one outflow. XIRR (Extended Internal Rate of Return) is used for SIPs or investments with multiple cash flows at different times.
Step-by-Step Calculation Example
Let's calculate the CAGR for an investment of ₹10,000 that grows to ₹20,000 in 5 years:
- Identify Values: Start = 10,000; End = 20,000; n = 5.
- Divide End by Start: 20,000 / 10,000 = 2.
- Raise to Power (1/n): 2^(1/5) = 2^0.2 = 1.1487.
- Subtract 1: 1.1487 - 1 = 0.1487.
- Convert to Percentage: 0.1487 * 100 = 14.87%.
This means the investment grew at a steady pace of 14.87% every year.