What is CAGR?
What does CAGR stand for? CAGR is the acronym used for compound annual growth rate. It is a mathematical representation of the constant rate of growth required for an investment to reach a certain endpoint, based on its starting value.
CAGR is frequently used in business and stock evaluations to compare multiple investments or strategies and as a method of defining the short-term requirements needed to meet a long-term goal.
A relatively simple calculation, the CAGR definition only requires the user to know the starting and final values of the asset, as well as the length of time between the two. The CAGR calculation can be made as follows:
In the above formula, N represents the number of compounding periods. The N value can be adjusted based on the preferences of the individual investor to represent any period of time such as weeks or months, though it is usually calculated in annual terms.
Below are two CAGR examples thatillustrate the advantages and disadvantages of what CAGR means in the stockmarket.
The CAGR calculation is useful when comparing different investments over time and can help to reduce the turbulence of normal volatility in the decision-making process, making it more easily understood.
CAGR also takes into account annual growth, which can be a more accurate picture of a stock than alternatives such as average rate of return (RoR), the caveat being that there have been no inflows or outflows of capital to the investment. Take the example below of someone investing $100,000 in a stock over a two-year period.
In the example above, the investor earns a +20% RoR in the first year and -20% RoR in the second. The average return is thus equal to 0% but the closing balance at the end of the second year is less than the starting investment. The CAGR is actually -1.35% as the value of the investment increased in the first year, meaning the -20% was larger than the initial gain.
As mentioned, CAGR is useful when comparing static investments over two specific periods in time. However, CAGR is unable to account for any inflows or outflows of capital during this time.
It also is not able to evaluate the effects of major volatility during the time frame that may influence the investor’s decision-making process. To illustrate this point, consider an investor who buys $100,000 of a stock and then reinvests an additional $10,000 each year for three years.
In the above example the CAGR is +9.13% but the real rate of return on the investment is 0%. The growth seen in the investment is a result of the addition of capital and not from any growth in the actual stock.
As evident from the above examples, CAGR does have its uses as well as its limitations when evaluating investment options. As with all other analytical tools it is most useful when evaluated within a framework of a broader technical and fundamental analysis.