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by Ashley GrasseWhat is CAGR? | Learn Everything About Compounded Annual Growth Rate
Choosing investments is tough, even for professionals. Using limited information, we try to guess the future value of investments in an unpredictable market.
In an attempt to manage this uncertainty, financial experts have developed many formulas, tools, and models to analyze and compare past performance in an attempt to understand how investments might perform in the future.
One calculation we can use when making broad comparisons over long periods is the Compounded Annual Growth Rate (CAGR). Read on to learn what CAGR is, how to calculate it, and the benefits and drawbacks of using this calculation to make investment decisions.
What is CAGR?
As the name suggests, CAGR is the average annual growth rate of an investment. The key words here are “average” and “annual.”
The Compounded Annual Growth Rate (CAGR) provides a smoothed-out look at how an investment grew on a year-to-year basis and does not include the volatile price fluctuations in between.
Another way to put it is that it’s the theoretical rate of return that was required to grow the starting balance of an investment to the ending balance.
A Simpler Way of Understanding CAGR
As an analogy, consider two airplanes coming in for a landing. The first airplane glides smoothly to the tarmac – a flawless landing. All the passengers disembark from an uneventful flight.
However, things are rough in the second plane. An engine explodes, a wing falls off, and the cabin depressurizes, but somehow the pilot manages to land this nightmare flight – barely. Despite the chaos, all the passengers survive and disembark safely.
While the experiences of the passengers from each flight were wildly different, the results of the flights were the same: all passengers departed safely and arrived safely. What happened in between doesn’t matter if we only care about safe departures and arrivals.
CAGR measures investments in the same way. We compare the starting value to the ending value to determine the simple rate of growth between the two, but we do not measure the volatility that may have occurred throughout this period.
CAGR Formula Explained
Now, let’s take a look at how to calculate CAGR yourself. There is some math here, but don’t worry. It’s pretty simple. To calculate CAGR for an investment, we need three data points:
- Ending balance – the value of our investment at the very end of the period we are measuring
- Beginning balance – our initial investment, or the value of the investment at the beginning of the period we want to measure
- Number of years – the number of years our investment grew, which can be fractional (e.g. 5 years and 6 months would be 5.5 years)
Once we have those numbers, we can do our calculations. The CAGR formula looks like this:
CAGR = [(ending balance / beginning balance) ^ (1 / number of years)] – 1 x 100
In English, that is the ending balance divided by the beginning balance, raised to the power of one divided by the number of years minus one, then multiplied by 100.
Finding the CAGR (Example)
To make more sense of this, let’s look at a practical example:
Let’s say we own stock shares of ABC, and we’ve held those shares for seven years. We’re trying to decide if we want to continue investing in this stock or invest in something else. As part of our analysis, we want to know the CAGR of our investment in ABC so far.
| Year | Stock Value |
|---|---|
| 2015 | 100 |
| 2016 | 117 |
| 2017 | 131 |
| 2018 | 124 |
| 2019 | 109 |
| 2020 | 99 |
| 2021 | 156 |
First, we need the ending balance, which is the last entry on the table: 156
Next, we need the beginning balance, which is the first entry on the table: 100
Finally, we need the number of years, which is the sum of all the years: 7
Following the formula, we can calculate CAGR like this:
[(156 / 100) ^ (1 / 7)] – 1 x 100 = 6.56%
Note that in our example, the stock price did not smoothly rise at 6.56% per year. Some years it was up; some years, it was down. But for CAGR, all that matters is the value at the end.
CAGR in Excel
Part of the reason CAGR is a useful measurement is that it can be calculated quickly. But if you want to calculate CAGR automatically using Excel functions, here is how we do it.
- To make it simple, we’ll use the same numbers from the example above. First, enter the data into a spreadsheet, as shown below.
- Now, enter the formula shown below into any cell. For our example, it looks like this:
=(B9/B3)^(1/7)-1
- Once you have the formula entered correctly, press “enter” to get the result. If you prefer, you can hit the “%” button in the toolbar to tell Excel to show the value as a percentage.
And there you have it, thanks to Excel magic.
Why is CAGR Important?
Now we know what CAGR is and how to calculate it, but how is this useful to investors like us?
The main value is that it gives us a standardized baseline measurement that can be used to compare and benchmark CAGR with different investments.
When we’re planning to invest, financial instruments can be difficult to compare because they have different volatility profiles. Graphs of bond prices show a gently sloping upward line, while stock price graphs can look like a 9.0-magnitude earthquake!
Making Better Comparisons Using CAGR
CAGR eliminates some of the volatility from the graph, so we can more clearly see baseline trends and make a better comparison. This way, you can compare dividend stocks, bonds, funds, indices, and just about any other kind of investment – all on an even playing field.
Once you have the historical returns of all your potential investments “translated into the same language,” it’s easier to see which one might be the better buy. But before you jump to any conclusions…
How is CAGR Deceiving?
Despite the usefulness of CAGR, it’s important not to misinterpret the results of this calculation. There are two key ways that CAGR can be deceiving.
1. Can Skew Towards More Positive Results
If you add funds to an investment, it will distort CAGR and make it look more positive than it might actually be. Remember, the utility of CAGR is to find a baseline so you can compare investments. If you add extra funds, it distorts the value of this calculation.
2. Does Not Account For Volatility
CAGR does not account for volatility. If an investment has a CAGR of 5% over 10 years, that doesn’t mean it had a consistent growth rate throughout that period. Maybe it did, maybe it didn’t but CAGR doesn’t tell us that.
Calculate CAGR with StockMarketEye
We hope you have a better understanding of CAGR, how to calculate it, and the benefits and drawbacks of including it in your investment analysis process.
While this calculation can tell us a lot about the historical performance of an investment, it’s unwise to depend on CAGR as your sole data point for making an investment decision.
Instead, use it as one of many tools to try and figure out which buy might be right for you.
The thing about investment analysis is that it requires data. Lots of data. Without accurate, up-to-date information, your investment choice is a guess at best. That’s where stock tracking systems like StockMarketEye come in handy.
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It allows you to check investment histories with the Back in Time feature and create watch lists and portfolio lists to see how several investments compare over time and so much more.
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