Compound Annual Growth Rate or CAGR

Often, we come across the term CAGR while analysing a particular company or comparing the growth of particular stock or the investment over a time frame. The term sounds very complex, however, it is simple and easy to understand. CAGR stands for compound annual growth rate. It measures the annual growth rate of an investment over the period of time, with the effect of compounding taken into account.

CAGR Explanation in simple words:

CAGR is a representation figure and is not a true value of anything. Also, there is an assumption here that whatever is earned gets reinvested in the next year. So, what does that mean? To explain this concept, let us understand with a simple example.

In the above example, we can see that in year 1, there is a profit of 20%, year 2 was 8%. In year 3, there was a loss of 4% compared to year 2. Subsequently, in year 4 and year 5, there was a net profit of 12% and 7% respectively.

However, if someone ask that what is the net profit we made in this case in the past 5 years, then we can achieve this through CAGR.

Calculation of CAGR:

In the above example, let’s say, that a person invests $100 to purchase a stock. This $100 is the principal amount, which is invested year 0. Next year, the stock price reaches $120, then we say that the person has made a 20% profit. Now, the person re-invests the profit and the principal amount. In this case, the principal amount in year 1 becomes $120. In year 2, the stock reaches $130. It means, the person makes an 8% profit by the end of 2nd year and so on.

The process we followed in the above example is called compounding in which the amount generated by the end of each year is re-invested in the next year until a specified term.

We can easily relate this concept to one of the mathematical concepts which most of us have come across during our school days “Compound Interest”.

Formula:

CAGR = ((FV/IV) ^(1/n)) -1

Advantage of CAGR:

• The biggest advantage of using CAGR is that it helps us to compare several investments over a similar investment horizon.
• Not only in finance, CAGR helps to calculate growth in various fields such as reviewing increase in production, sales, viewership, stock performance etc over a certain period of time.

Disadvantage of CAGR:

• CAGR does not calculate the profitability of an investment sidelining the cash inflow and outflow that occurs during the particular time frame.
• It does not consider the investment risk during the period.

Simple Interest vs. Compound Interest

Simple Interest indicates the amount that a person earn from the money which is originally invested. The interest is calculated on the principle amount and is calculated using the below formula.

Example:

If I invest $100 at a simple interest of 10% for 5 years, I would get $50 as interest after 5 years. The total amount which I would get in this case would be $150.

On the other hand, if I invest $100 at compound rate of 10% for 5 years, I would get $161.05 as interest. Total amount which I will receive would be $261.05.

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