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How Do You understand Compound Annual Growth Rate(CAGR) with formula

Hamza Haroon | July 16, 2021 How Do You understand Compound Annual Growth Rate(CAGR) with formula

Table of contents

    What is Compound Annual Growth Rate(CAGR)?

    CAGR abbreviated for compound annual growth rate, for over a certain period of more than one year, is the average annual growth rate of an investment.

    During that era, CAGR notifies you about the amount a fund earned each year.

    For the growth over several years, CAGR is a useful metric. The CAGR meaning in stock market is considered as the growth rate from the initial investment value to the final investment value if you assume that the investment compounds throughout the course of the period.

    CAGR Formula

    The compound annual growth rate is calculated using the formula:

    CAGR = [(Ending Value/Beginning Value) ^ (1/N)]-1

    Where, Revenue Year (n)= nth year Revenue

    Revenue Year (1) = 1st year Revenue

    What is an Acceptable CAGR?

    The compound annual growth rate or CAGR varies distinctively among various industries and the time period they have been in the market.

    The CAGR thus has different acceptable values for each industry and for the different time periods.

    This difference is due to different growth rates and industry sizes. Nevertheless, an average CAGR value that is normally accepted by each and every industry lies somewhere between 5-10%.

    In the long run, large and successful firms have historically provided their investors with a return of 8 to 12 percent.

    Therefore, long-term investment horizons might invest in large-scale enterprises, in search of steady profits. In the long run, the potential compound annual growth rate can be between 8 and 12 percent.

    On the other hand, small and medium-sized enterprises are more likely to make bigger returns. But this is an extremely volatile investment.

    Investors who understand and are prepared to bear the risk can thus invest in these firms. Return on these investments historically amounted to more than 15%.

    What is a Healthy CAGR?

    When it comes to equity investment, there is no clear figure for a good CAGR. There are several elements in combination.

    But ideally for most assets, the CAGR should be higher than the saving account interest rate equities and fixed income.

    However, the compound annual growth rate is ideal for big businesses in terms of sales of 5-12%. In the same way, a CAGR of between 15% and 30% is found to be appropriate for small firms.

    Contrarily, CAGR ranges from 100 to 500% for start-up firms. Moreover, these rapid growth rates are not fully unusual in the early phases of business.

    Which is Better: CAGR or Absolute Return?

    Now you must be aware of the concept of CAGR and how we calculate CAGR. The absolute return in contrast is the growth or reduction in percentage terms achieved by an investment over a certain period.

    The following is calculated:

    Absolute return = 100 * (Price of Sale - Price of Cost)/(Price of Cost)

    As a comparison between these returns, the absolute return which is also known as point to point return and compound annual growth return, to decide which is better.

    • The CAGR offers a genuine and fair perspective on the success of your assets when your investment holding duration is above 1 year.
    • The CAGR is considered a better metric than absolute return because the compound annual growth return takes into account how quickly and at what rate your assets increase.

    Can CAGR be negative?

    If your present investment valuation is less than your investment costs, it is possible to have negative compound annual growth return.

    The negative CAGR however, shows that investing in a certain plan is not providing good results. Then it is dependent upon a person to decide whether to sell the investment and book loss or to wait for the investment to become a profit.

    How to calculate CAGR?

    For the purpose of calculating the CAGR, the final investment value will divide the initial investment value, which will result in the total investment growth rates.

    For the aforementioned results the Nth Root has to be calculated, where N refers to the number of years your firm has invested in an investment.

    Then, lastly, one is subtracted from the results, this shows the CAGR % of the results of the calculation.

    This calculation initially will provide you the entire return on a given investment, which will annualize its second portion, the Nth root, annualizes the return throughout the duration of that investment.

    How much CAGR is good for stocks?

    The returns on your investments are computed using the CAGR procedure when you invest in stocks. This approach is the best way to calculate returns since it takes compounded returns into consideration.

    In the case of stocks, the investment time is a few years, and so the actual returns are not just the difference between investment value and appreciated value in a percentage of terms. CAGR technique is therefore utilized for the calculation of returns for Stocks.

    Hence, to assess the success of your stock investments over a specified period of time, you may calculate their compound annual growth rate, often known as CAGR. You can get a sense of how much your stocks have gained or lost over the course of the year by using this metric.

    For stocks investments, a good compound annual growth rate however is calculated from 10% to 15%.