Compound annual growth rate (CAGR) is the cumulative performance of an investment over a period of time, assuming the profits were reinvested at the end of each year of the investment’s lifespan. It is used to measure and compare the performance of investments, or to project their expected future returns.
Formula for finding CAGR is
CAGR = (EV/ BV) ^(1/N) -1
where EV is ending value of investment, BV is beginning value of investment and N is number of investment period.
For example, assume that stock price was Rs.100 three year ago. It appreciated by 25% to Rs.125 in the following year. Further appreciated to Rs.150 in the next year. Using above formula, Compound Annual Growth Rate of the stock will be 22.47%.
CAGR vs Absolute Return
Absolute Return is the total return earned by an investor in a investment from the beginning to the present time. CAGR describes the rate at which an investment would have grown if it had grown the same rate every year and the profits were reinvested at the end of each year. Absolute returns ignore the time value of money. On the other hand, CAGR considers the duration for which the amount has remained invested.
For example, if an investor had invested Rs. 100 three years ago and that amount has increased to Rs. 174. Then absolute return on the investment is 74% to date. On the other hand, for the same investment if CAGR is 20.27%. It implies that the average return is 20.27% per year for the last three years.
CAGR Use In Mutual Fund
CAGR can be used to ascertain whether a mutual fund is worth investing or not. But two or more mutual funds may have same CAGR. A possible reason is the variation in growth of multiple funds. For instance, one fund may have shown rapid growth in the first year while the other may have shown in the last year. So CAGR should not be the only criteria to evaluate a fund’s performance. Other types of returns along with CAGR should be used to evaluate a fund’s performance.