What Is CAGR?
Any investment that gives an investor the benefit of compounding can help him/her to build and increase his/her wealth. Compound Annual Growth Rate shows the growth of the amount invested by an individual over a time horizon. CAGR is the return required to grow the initial investment to the portfolio’s present value.
How Is CAGR Different From Absolute Returns?
Absolute return is the total return earned by an investor in a fund from the time he/she invested the amount to the present time.
So, if an investor had invested Rs. 100 three years ago and that amount has increased to Rs. 174 then it means that the invested amount has given an absolute return of 74% to date.
On the other hand, for the same investment if the CAGR is 19% then it implies that the average return is 19% per year for the last three years.
Generally while discussing with others about the returns offered on a mutual fund scheme or a fixed deposit or while comparing returns offered by different investment options we look at the CAGR which is the annualized rate of return.
Most of the time, when investors are relying on absolute returns to find out the performance of their investments, they are ignoring the time value of money.
On the other hand, CAGR considers the duration for which the investor has remained invested. CAGR gives an approximate rate at which the investment could rise if there is volatility in the market.
How To Calculate CAGR?
CAGR = (FV / PV) 1 / n – 1
It is a mathematical calculation that determines the real-time CAGR for any organization. The values stand for the following:
|N||The time period in years|
An example of CAGR calculation
If you have an initial investment of Rs. 1 Lakh in a business, it constitutes the PV. If the total investment has swollen to Rs 10 Lakh (FV) after 5 years (N), the CAGR is:
(10,00,000/1,00,000)1 / 5 – 1 or 0.589
Thus, the CAGR percentage is CAGR x 100 or 58.9%.
CAGR’s Use In Mutual Fund Industry
In order for an investor to know whether it is worth investing in a particular mutual fund, the CAGR becomes an important measure for the investor to gauge the performance of a mutual fund. CAGR puts the concept of compound interest and makes it easier to see the annual growth rate of the fund.
Difference Between IRR and CAGR
Both IRR and CAGR are used by investors to compare the returns of investments. In order to find out the return for CAGR, initial cash outflow and a cash inflow, in the end, is used. On the other hand, IRR is made up of multiple cash inflows and outflows to find out the return. IRR is more flexible than CAGR.
CAGR calculation is very simple and does not require an individual much time to calculate CAGR. On the other hand, when the complicated investments and projects are involved with multiple cash flows then IRR is calculated.
Things To Keep In Mind About CAGR As An Investor
As a mutual fund investor, note that two investments may have the same CAGR but one may be a better option than the next. A possible reason for the variation in growth for both funds. For instance, the first fund may have shown rapid growth in the first year while the other one showed in the last year.
So CAGR should not be the only criteria to evaluate a fund’s performance. There are other types of returns as well that can help you evaluate a fund’s performance. Some of them are listed below :
- Annualised Returns
- Trailing returns
- Returns since launch
To sum up, CAGR is a more reliable parameter to track the growth of your investment. Because unlike absolute rate of returns CAGR does take compounding into consideration as well, thereby showing a more accurate estimate. However, while evaluating the performance of your investments also consider other factors to reach the right decision.
Disclaimer: The views expressed in this post are that of the author and not those of Groww