The Compound Annual Growth Rate (CAGR) may be the key to better investment earnings. The CAGR formula calculates year-over-year growth rates and helps chart investment performance. It also allows investors to see how similar investments have fared over the same length of time. If you’re in need of a financial advisor, the CAGR formula can help you compare advisors and see who is getting their clients the most for their money.
CAGR at a Glance
The CAGR is a means of calculating the total return on an investment. By using an investment’s start value, its final value and the time period between the two, it offers a measure of year-to-year return.
By determining the CAGR, an investor can figure out the rate of return required for an investment to grow from its starting balance to its final balance. If profits are reinvested at the end of each year of the investment, the CAGR can give an accurate representation of potential growth. It smooths out fluctuations in investment performance and prevents aberrant years from skewing the final result.
It also functions as a tool for comparing investments of different types. If you have investments in equities and other investments in accounts with fixed interest rates, the CAGR can smooth out stock volatility and create a more balanced view of both investments.
The CAGR can also be used to track business performance by comparing factors including market share, customer satisfaction and capital investment. It can be an ideal means of detecting a company or investment’s strengths and weaknesses to determine what changes need to be made.
How to Calculate CAGR
To use the CAGR formula, you can go old-school and use a calculator with an integer button. However, if you use spreadsheet software like Microsoft Excel, it will typically allow integer calculations. If you’re having trouble with either method, there are always CAGR calculators.
The typical CAGR formula is as follows:
Ending balance/Starting balance^(1/n)-1
The n in the formula is the number of years you’ve held the investment, which is a good place to start if you opened your investment portfolio with $5,000 three years ago.
Let’s just say that investment grew by $2,000 in its first year, $1,000 in its second year, and $3,000 in its third year. That’s $6,000 in earnings over three years. Here’s how that end balance of $11,000 looks in the CAGR formula:
Alternatively, you can use the decimal variation for the number of years. Four years would be .25 and two years would be .50. For our example, we could also say:
In either formula, the end result is the same: 30.06% as the compound annual growth rate.
CAGR Formula Variation
One minor CAGR complication is that investments aren’t always held for full years. If you bought a stock halfway through the first year and sold it in the first quarter of the last year, it will be somewhat harder to calculate the CAGR.
However, if you break down each year into days, you can divide the total number of days by 365 and get a more accurate figure. For example, let’s say you bought a stock on June 3, 2015, and sold it on Feb. 2, 2019. That mean you owned it for 211 days in 2015, for all of 2016 through 2018, and for 33 days in 2019. That’s a total of 1,339 days, or 3.67 years.
The CAGR formula smooths out volatility, which may not be the best approach to a volatile investment. It also doesn’t consider that an investor might add to or subtract from a portfolio during a certain period.
The CAGR only takes into account the beginning and end balances. Additional funds or investments would result in an inflated CAGR. Those funds aren’t “annual growth,” they’re added principal.
The CAGR also can’t predict the future: It can only judge past performance. If you’re using a short time frame, like three years, the CAGR in the future may not match expectations. Using a longer term for the formula may help, but investors still can’t assume the rate will stay the same.
The CAGR is an important measure of a stock or a group of stocks’ performance against the market index. It determine if a specific stock or set of investments is worth continued investment or if you should move your money elsewhere.
The stock market is routinely in flux. CAGR not only helps calculate how one stock has performed over the years, but you can compare a stock to others and how those have performed over the years. Also take into account how the CAGR compares to average market conditions. It can help you determine if you’re on par with the market. If not, you may need to further diversify your investments.
Investment Calculation Tips
- The CAGR formula is tricky. A financial advisor may be able to help. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- If there are other portions of your investment calculations tripping you up, SmartAsset has other tools that may help. An investment calculator may clear up the big picture. Meanwhile, an asset allocation calculator can help determine your risk tolerance.
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