When we look at the returns an investment gives on Rs.1 lakh, what would be a more precise picture?
- 50,000 gained in 10 years, where it is unclear whether it was a consistent Rs.5,000 each year or varied every year or
- A return of 5% every year
The second scenario is similar to the clarity brought by CAGR—Compounded Annual Growth Rate. What is it, and how does it work? Let’s understand by briefly examining the concept of CAGR and the CAGR calculator.
What Is CAGR?
CAGR, or Compound Annual Growth Rate, helps you understand how much your investment grows on average each year over a specific period. Unlike absolute returns, which only show the total gain, CAGR gives a clearer picture by considering compounding, where your returns build upon previous gains.
For example, if you invest ₹25,000 in 2016 and it grows to ₹50,000 by 2021, the absolute return is 100%. While that looks impressive, it doesn’t tell you how much your investment grew each year. This is where CAGR comes in—it calculates the average annual growth rate, making it easier to compare different investments. If the CAGR in this case is 14.87%, it means that, on average, your investment grew by 14.87% per year, though actual yearly growth may have varied.
CAGR smooths out fluctuations, helping you track performance and make better investment decisions. Since it factors in compounding, it provides a more realistic measure of long-term growth.
How Is CAGR Calculated?
CAGR can be calculated manually using the CAGR formula or an online financial calculator based on the same CAGR formula. The formula is-
CAGR = [(FV / PV)^1/n] – 1
Here,
- FV represents the future value or the end value of your investment
- PV represents the present value or the starting value of the same
- n stands for the tenure of the investment in years
For instance, say you made an investment of ₹75,000, and over eight years, it grew to ₹1,20,000.
To calculate CAGR, we use the formula:
CAGR = [(FV / PV)^1/n] – 1
Applying the values:
CAGR = (1,20,000 / 75,000)^(1 / 8) – 1
CAGR = (1.6)^(0.125) – 1
CAGR ≈ 6.14%
This means that, on average, your investment grew by approximately 6.14% per year over the eight-year period, even though actual growth may have varied each year.
How Does An Online CAGR Calculator Work?
An online CAGR calculator helps you determine your investment returns with ease. To use it, enter three key details:
- Total Investment (the amount you invested)
- Final Maturity Value (the value at maturity)
- Duration of Investment (the number of years you stayed invested).
After providing these inputs, simply click “Calculate” to see your total gains along with the CAGR or Absolute Returns in percentage. The calculator also visually represents how your investment has grown over time, making it easier for you to analyze past performance and make informed investment decisions.
How Can Investors Use CAGR?
- CAGR helps you compare different investments by giving you a standardized measure of average annual growth over a specific period.
- It helps you with long-term investment planning by estimating the potential future growth and allowing you to make more informed decisions.
- By looking at CAGR, you can assess the stability and risk associated with an investment over time.
- You can evaluate the performance of investments by comparing their CAGR with benchmark indices or industry standards.
- CAGR gives you a clearer picture of your investment growth without being affected by short-term market fluctuations.
Bottomline:
CAGR is a powerful tool that helps you track the growth of your investments over time, providing a more accurate picture of their performance. It allows you to compare different investments on a consistent basis, plan for the future, and assess the stability and risk of your portfolio.
Whether you’re evaluating past investments or projecting future growth, CAGR simplifies complex data into a useful, easy-to-understand metric. By understanding CAGR, you can make more informed decisions, manage your investments effectively, and ensure your financial goals are on track for the long term.
FAQs:
- How is CAGR different from the average growth rate?
CAGR measures the consistent annual growth rate of an investment over time, considering compounding, while the average growth rate is a simple arithmetic mean of annual returns without factoring in compounding.
- What is a good CAGR?
A good CAGR percentage varies depending on the investment type. For equities, a 12% CAGR can be good, while for lower-risk investments like FDs or debt funds, 7-8% may be considered good, especially considering inflation has averaged 6% in recent years. Factors like risk and potential returns play a key role in assessing CAGR.
- Can CAGR also reflect risks?
CAGR itself doesn’t directly show risk factors, but it can indicate stability over time. A consistently high CAGR may suggest reliable growth, while large fluctuations in CAGR over different periods could imply higher risk or volatility in the investment.