Introduction

CAGR, or Compound Annual Growth Rate, is a crucial financial metric that displays the annual growth rate of an investment over a specified period. This measurement is widely used by businesses and investors to evaluate investment options and conduct financial analysis. In this article, we will outline the steps to calculate CAGR and provide an example for better understanding.

What is Compound Annual Growth Rate (CAGR)?

Compound Annual Growth Rate, often abbreviated as CAGR, is a financial term that represents the average yearly rate at which an initial investment grows over a defined period. This metric considers the impact of compounding and allows for a straight-forward comparison of various investments. CAGR helps gauge investment performance more accurately than simple annual growth rates.

Calculating CAGR

To calculate CAGR, you will need three pieces of information:

1. Initial investment value (V0)

2. Final investment value (Vn)

3. Investment period in years (n)

CAGR Formula:

CAGR = [(Vn / V0)^(1 / n)] – 1

Step-by-Step Calculation:

1. Divide the final investment value by the initial investment value.

Result: Vn / V0

2. Calculate the root of the result obtained in step 1 using exponentiation.

To achieve this, raise the result to the power of (1 / n).

Result: (Vn / V0)^(1 / n)

3. Subtract 1 from the result obtained in step 2.

Result: [(Vn / V0)^(1 / n)] – 1

Example:

Suppose you’ve made an initial investment of $5,000, and after five years, its value has grown to $7,500.

Given:

Initial investment value (V0) = $5,000

Final investment value (Vn) = $7,500

Investment period in years (n) = 5

CAGR Calculation:

Step 1: Vn / V0 = 7,500 ÷ 5,000 = 1.5

Step 2: (1.5)^(1/5) ≈ 1.084

Step 3: 1.084 – 1 ≈ 0.084

CAGR ≈ 8.4%

With a CAGR of approximately 8.4%, this sample investment has achieved an average annual growth rate of about 8.4% over the five-year period.

Conclusion

CAGR is an invaluable tool in evaluating the performance of investments and understanding long-term growth potential. By using the CAGR formula, you can effectively compare different investments and make informed decisions for your financial goals. Keep in mind that while helpful, CAGR only represents historical performance and should be used alongside other financial metrics for a comprehensive investment assessment.