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What is the Compound Annual Growth Rate?
Compounded annual growth rate (CAGR) depicts the cumulative performance of a particular variable over a significant period of time and is used to measure relative profitability of businesses. CAGR is often associated with specific parameters which indicate the performance of a company over a fixed period, such as sales, revenue, earnings, etc.
For example, Reliance Industries Ltd. experienced a market capitalisation compound growth rate at 31.5%, while earnings grew at 26.7% CAGR. This means that the average market capitalisation grew at 31.5% every year for the past five years, while earnings registered an average growth of 26.7% year on year.
Compound Annual Growth Rate Formula and Calculation
CAGR = (End value/ Beginning value) ^1/n -1
Where n = investment period
Let’s demonstrate this with an example. Assume Aritra invested Rs. 1,000 in an ELSS fund for three years. While the total NAV value remained Rs. 1,000 for the first year, it increased to Rs. 1,100 in the second year. Upon maturity of this fund, final NAV stood at Rs. 1,300.
|Year||NAV (in Rs.)|
Therefore, CAGR growth = (End value/ Beginning value) ^1/n -1
= (1300/ 1000) ^1/3 -1
Thus, the NAV of this ELSS fund grew at a CAGR of 9.13% for three years.
Individuals might calculate total CAGR online using a CAGR calculator, or excel software, to determine the growth rate of invested funds.
CAGR and the Stock Market – When Should You Invest?
CAGR of total returns in the stock market depicts the rate of growth in average returns generated. Before investing in any security in the stock market, comparing the expected rate of return with the CAGR is vital, as it depicts whether the investment is profitable or not.
CAGR helps individuals analyse the long term growth of a company, minus all short term variations. It helps eliminate the unsystematic risk associated with stock market instruments, owing to variations in the economic conditions of a country.
As CAGR smoothens out short term variations and hence, reflects the growth rate pro forma (excluding non-recurring fluctuations), investors can get a clear idea about the performance of a company due to its internal structure.
For long term investment purposes, comparing the compounded annual growth rate is crucial to understand whether a stock market tool is a value investment tool or not. Value investment tools often demonstrate high CAGRs for an extended period, which effectively eliminates any short term variation.
Investing in value stocks helps individuals realise a substantial rate of return, facilitating capital gains in the long run.
Advantages of CAGR
CAGR is one of the most popular variables used to determine the profitability of an investment venture, as it demonstrates the average performance of the same over a period of time. Short term CAGR incorporates all underlying factors affecting the performance of such securities, including market parameters.
CAGR for an extended time rules out all short term variations, as the security recovers quickly from such market shocks, helping individuals determine the true potential of such companies respectively.
Limitations of CAGR
- Does not reflect market volatility
CAGR represents an average growth of a stock or associated business variables provided no external influence was present. It does not incorporate the crucial factor of stock market fluctuations, which has a deep-rooted effect on the performance of listed companies. CAGR evens out all variations in the annual return rate of securities while considering an average of the same.
For example, a stock market instrument can have a return of 25% during the first period of investment, 9% in the second year, 19% in the third year, and 17% in the fourth year.
|S. No.||Year||Rate of return YoY (%)|
The return CAGR of the security = (25+9+19+17)/4
This value shows that security has experienced an average CAGR growth at 17.5% every year for four years. But as per obtained data, the security enjoyed 25% growth in the first year, owing to positive market fluctuation. In the second year, the value of the stock plummeted to 9% due to any adverse event in an economy, or the capital sector.
- Not ideal for risk assessment
As CAGR does not reflect the volatility of a security trade in the stock market, individuals might not get a clear idea regarding the performance of the instrument in the vent of extreme fluctuations. The behaviour pattern of respective securities cannot be judged by just comparing the CAGR of a company, as it does not take into account short term variations. Other technical analysis tools should be utilised simultaneously to make accurate predictions regarding the performance of a stock market instrument to ensure investment in profitable schemes.
Owing to its respective limitations, compounded annual growth rate often fails to grasp short-run irregularities of stocks due to both internal and external factors. In this regard, looking into other technical analysis tools is crucial for investors having a short term investment goal.
- Sharpe ratio
The Sharpe ratio depicts the percentage of risk associated with security, and the extent of fluctuation of the same in the case of stock market movements.
Sharpe Ratio = (Average rate of returns – risk-free rate) / Standard deviation
In this formula, risk-free return demonstrates the ROI if the total investment portfolio was deposited in non-market linked tools such as savings or fixed deposits. Standard deviation takes into account the past performance of a security and shows the degree of difference between a benchmark index or expected rate of return with the actual gains or losses realised.
Analysing the Sharpe ratio along with the return CAGR, helps individuals get a precise idea about the risk factor associated with corresponding investments, as well as the potential of a company to generate subsequent profits.
- Internal rate of return
Internal rate of return uses the concept of discounted cash flows and net present value to determine the profitability of a business venture. A projected internal rate of return higher than the expected value increases the chances of earning high profits by investing in corresponding stocks.
While compounded annual growth rate poses as one of the most popular analysis tools considered by most investors before pooling their money into security, it does not provide a comprehensive outlook towards all associated risks. However, projected growth rates depicted through long term CAGR of various underlying parameters show a pattern of growth of a respective company, as well as the future potential of development.