Compounded Annual Growth Rate(CAGR) is a widely used return metric because it truly captures the year-on-year return earned by an investment, unlike absolute return that captures the point-to-point return from an investment without considering the time taken to earn it.
CAGR is excellent for tracking long-term, steady growth and is often used by individual investors and fund managers. IRR, on the other hand, is better for investments with irregular cash flows, like business projects or real estate, as it gives a more detailed look at profitability by considering the timing of returns.
Disadvantage of CAGR: Smoothing and Risk
Building on the above example, the CAGR correctly shows the ending value of the investment if a –3% CAGR was applied over a two-year compounding period. However, the CAGR assumes that the investment falls at a constant 3%, when, in fact, it grew by 25% in the first year.
Application in Business Strategy
CAGR helps in forecasting revenue growth, setting realistic goals, and assessing the viability of long-term projects. Meanwhile, AAGR offers a quick glance at steady growth patterns, assisting in short-term planning or performance assessment over consistent periods.
The main difference between the CAGR and a growth rate is that the CAGR assumes the growth rate was repeated, or “compounded,” each year, whereas a traditional growth rate does not. Many investors prefer the CAGR because it smooths out the volatile nature of year-by-year growth rates.
The Rule of 70 Formula: It means, the doubling time is simply 70 divided by the constant annual growth rate. For instance, consider a quantity that grows consistently at 5% annually. According to the Rule of 70, it will take 14 years (70/5) for the quantity to double.
Next, determine the ending value, which is the value at the end of the specified period. Now, calculate the total number of years over which the growth occurred. Use the CAGR Formula: CAGR = (Ending Value / Beginning Value)^(1 / Number of Years) – 1.
It's one of the most accurate ways to calculate and determine returns for individual assets, investment portfolios, and anything that can rise or fall in value over time. CAGR is a term often used when investment advisors tout their market savvy and when funds promote their returns.
How do you convert CAGR to annual growth? The CAGR or compounded annual growth rate represents how much your investment grew or generated by way of returns each year on a compounded basis. It is therefore already an annual growth rate and does not need to be converted to annual growth.
The IRR doesn't take the actual dollar value of the project or any anomalies in cash flows into account. If there are any irregular or uncommon forms of cash flow, the rule shouldn't be applied. If it is, it may result in flawed findings.
For irregular investments with detailed cash flow data, XIRR is often more useful and accurate than CAGR since it accounts for the timing and size of all cash inflows and outflows. However, for regular investments focused on long-term growth, CAGR may be sufficient and easier to calculate.
Both CAGR and absolute returns are considered valuable metrics when it comes to evaluating investment performance, but the key difference lies in their approach to time. Generally, CAGR is a preferred metric for longer-term investments.
The formula to calculate CAGR divides the future value (FV) by the present value (PV), raises the figure to one divided by the number of compounding periods, and subtracts by one.
As previously mentioned, Compound Annual Growth Rate measures the annualized growth rate of an investment over a specific time period with compounding returns. An example of this could be, if a stock grew from $10 to $20 over 5 years, its compounded annual growth rate would be 14.8%.
What Is the Major Measure of Economic Growth? While there are a number of different ways to measure economic growth, the best-known and most frequently tracked is gross domestic product (GDP).
Usually, anything under an 8% CAGR is poor, but a good rate really does depend on the specific organisation. For example, companies who have been around for 10 or more years may see a CAGR of 8%-12% which is a good rate of sales for the amount of time they have been in business.
Compound Annual Growth Rate or CAGR is the annual growth of your investments over a specific period of time. In other words, it is a measure of how much you have earned on your investments every year during a given interval.
What is the Rule of 72? Here's how it works: Divide 72 by your expected annual interest rate (as a percentage, not a decimal). The answer is roughly the number of years it will take for your money to double. For example, if your investment earns 4 percent a year, it would take about 72 / 4 = 18 years to double.
In other words, AAGR is a linear measure, whereas CAGR factors in compounding and “smoothens” the growth rate. For the most part, AAGR is viewed as a simpler, less informative measure because the metric neglects the effects of compounding, a crucial consideration in the context of investing and portfolio management.
CAGR is a simple metric that measures the average rate of growth of a sum, be that a figure like sales or an investment, over any number of periods. It's easy to picture visually: In Example 1 above, a $1.00 investment grows by 20% for three years to a value of $1.73. The CAGR is 20%.
However, the CAGR should ideally be more than the saving account interest rate for most investments – equity or fixed income. Historically, in the long term, large and strong companies have given a return between 8% to 12% to their investors.
It's simple math: If your business is growing at a rate of 15% per year it will double in size in 5 years (4.8 to be exact). At 30% growth, your company will double in size in 2.4 years. At 5% growth, you've got a 14.4-year journey ahead of you.
The IRR is also a rate of return (RoR) metric, but it is more flexible than CAGR. While CAGR simply uses the beginning and ending value, IRR considers multiple cash flows and periods—reflecting the fact that cash inflows and outflows often constantly occur when it comes to investments.