Compound Annual Growth Rate (CAGR) is a critical financial metric that investors across the globe use to evaluate the performance of their investments over a certain time period. The primary objective of the CAGR formula is to provide a smoothed yearly growth rate that irons out fluctuations that might occur in the year-to-year growth rates.
CAGR is extensively used to compare the average annual growth rates of investments in volatile contexts, such as the stock market. For instance, investors may use the CAGR to compare the annual growth rates of two different stocks that they held for a similar period.
The CAGR is not the actual return rate but is the mean annual growth rate that smoothens the path of an investment if it has grown at the same rate each year.
CAGR Formula: Understanding the Basics
Understanding the CAGR formula is rather straightforward as it involves the basic principles of mathematics. The CAGR is calculated by taking the nth root of the total return on investment, where n is the number of years, and then subtracting one.
The formula of CAGR is:
CAGR=[(End Value/Start Value)^(1/n)] -1
The three key variables in this formula are:
– Start Value: It represents the initial value of the investment
– End Value: It signifies the ending value of the investment
– n: It represents the period of investment in years.
Let’s consider an example to get a better understanding of how to calculate CAGR using the formula.
Suppose you invested INR 15,000 in a mutual fund scheme five years ago, and today, the value has grown to INR 20,000.
You can use the CAGR formula to calculate the average annual return on your investment as follows:
CAGR = [(20000/15000)^(1/5)] -1
The result would be approximately 0.06, which when multiplied by 100 gives an annual growth rate of about 6%.
It is essential for investors to note that the CAGR formula does not consider the risks associated with investments, such as the volatility in stock markets or the fluctuations in the share prices. As such, while the CAGR formula offers a simplified depiction of returns over a specific period, potential investors should consider other metrics to get a wholesome view of their potential investments.
Please take into account that investing in financial markets involves high levels of risk, and you must be willing to accept losing your investment. Therefore, you must always gauge the pros and cons before making any decision to trade in the Indian financial market. Performing a detailed analysis is always a smart approach to investing and using metrics like the CAGR formula is just one way to study the return on investment.
