When it comes to financial analysis, the compound annual growth rate (CAGR) is one of the most important metrics to understand. If you are in the investment world, you will need to have some understanding of this concept to be successful.
The way your investments grow over time depends on several factors. The most important factor is the rate of return that you earn on your investment so the higher the rate of return, the faster your money will grow.
What is CAGR
CAGR is a measure of an investment’s yearly growth rate over time, taking into account the influence of compounding. It’s typically used to calculate and compare the past performance of investments as well as project their future returns.
In simple terms, CAGR is the rate at which an investment grows over a period of time. It’s important to note that CAGR is not the same as the annual growth rate (AGR). AGR measures the growth of an investment over a one-year period, while CAGR takes into account the influence of compounding, which makes investments grow at a faster rate over time.
Why CAGR is important
Decision-making is probably the most important function of any business, and choosing the right investment is one of the most important decisions that a business or individual can make.
The problem is that there are so many different investments to choose from, and it can be difficult to know which ones will perform well in the future. This is where CAGR helps investors and businesses make better decisions.
CAGR is a useful metric because it allows you to compare the performance of different investments on a level playing field. When you compare two investments with different CAGRs, you are able to see which one has grown at a faster rate over time. This can help you make better decisions about where to invest your money in the future.
What is the formula of CAGR
Here is the formula of CAGR-
CAGR = (Ending value / Beginning value) ^ (1/n) – 1
Where,
CAGR = Compound Annual Growth Rate
Ending value = Value of investment at the end of the period
Beginning value = Value of investment at the beginning of the period
n= number of years
As you can see, the CAGR formula is pretty simple. All you need is the beginning and ending value of an investment, and the number of years that have passed. Once you have those numbers, you can plug them into the formula and calculate the CAGR.
Example of Compound Annual Growth Rate (CAGR)
To help you understand how CAGR works, let’s look at an example.
According to the formula, let’s say, you have invested $10,000 in XYZ stock five years ago. The value of your investment today is $15,000.
Plugging those numbers into the CAGR formula, we get:
CAGR = ($15,000 / $10,000) ^ (1/5) – 1 = 10.51%
This means that your investment has grown at a compound annual growth rate of 10.51% over the past five years.
If you want the formula in Excel, let us know in the comments below.
Conclusion
CAGR or Compound Annual Growth Rate is a very important metric to understand if you are involved in the investment world. It allows you to compare the performance of different investments on a level playing field, and make better decisions about where to invest your money in the future. Understanding how CAGR works will not only make you a better investor, but it will also help you make better decisions about your finances in general.
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