Compound Annual Growth Rate (CAGR)

Compound Annual Growth Rate (CAGR) is a (term) calculation that help’s you to know how much investment grew over a specific period of time. CAGR can be used to measure investments of different types with one another. Scientist of this century ,Nobel Prize winner in Physics Albert Einstein quoted once about same. This classic statement is vital for wealth building .

Compound Annual Growth Rate (CAGR)

Without delay let us know how much importance does it have in our life.

There are different kinds of returns that you need to be aware of, before knowing CAGR .

Absolute Return : 

As an illustration let us suppose you bought share of TCS at 1800 and sold it 1880 .How much percentage return did you generate? Use absolute return when your time frame is for a year or lesser. To know return in absolute terms we will use the formula below.

The formula to calculate the same is [Ending Period Value / Starting Period Value – 1]*100

=[1880/1800-1]*100

=0.044*100

=4.44%

This is return that your trade or investment has generated in absolute terms.

Compounded Annual Growth Rate (CAGR) :

In case you want to compare two investments CAGR helps you. CAGR takes into the account the period for which you stayed invested . In other words you use CAGR when you want to check returns over multiple years.

To calculate Compound Annual Growth Rate (CAGR) You must know these three numbers.

1. The investment made in the initial year (the first year of investment)

2. Value of investment at the end of the year

3. Tenure of investment.

The formula for CAGR is :

Compound Annual Growth Rate (CAGR)

Applying this to previous TCS share (Assume you hold it for 2 years):

CAGR={[1880/1800]^(1/2)-1}   = 2.2% per year

Tip : If you are using a financial calculator, use the yx button to raise ( 1880/ 1800) to the power of 0.5 (since 1 / 2 = 0.5 ).

This means the investment grew at a rate of 2.2% for 2 years.

For this reason CAGR is a better measure of return over time . Average annual return disregards the effects of compounding. CAGR, on the other hand represents , consistent rate at which the investment would have grown if the investment had compounded at the same rate each year.

Conclusion :

Absolute return doesn’t take into account the rate of return over a period of time. Absolute return value is like measuring how many kilometers you traveled while CAGR is like measuring how many kilometers per hour you traveled .Most of the investment companies including mutual funds use compound interest to compute returns .

This the reason Compound Annual Growth Rate (CAGR) been called eighth wonder of the world.

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