Compounded Annual Growth Rate
So, a jargon! That’s terrible! We like simplicity and whenever we happen to come across jargon, we feel pretty lost. Is this your story too? If so, let us get together and try to solve the problem together. Today we are going to try and understand the concept of Compounded Annual Growth Rate, often abbreviated as CAGR.
Now the questions that need to answered are:
- What is Compounded Annual Growth Rate?
- In which context do we use it?
- Why is it necessary?
- How is CAGR calculated?
We will try to answer these questions in this article and at the same time, keep those answers as simple as possible because we hate being complex!
Let us start…
What is Compounded Annual Growth Rate?
We will ditch the textbook definition because it will only make us nervous. So, we will put it in a way we managed to understand it. Let us first concentrate on the very basics. CAGR is used for measuring growth rate of anything related to money.
Now there is a slight problem with this. CAGR doesn’t really give you the actual growth rate or perhaps, return rate. What it really does is that it gives a projection. What does that mean? Let us get into some numbers, shall we?
Let us say that you have INR 10,00,000 (10 lakhs) cash in hand and you want to invest it somewhere, say mutual fund. You have also decided that you will keep your money invested for a period of 5 years straight, i.e. you will not try to take the money out before 5 years are completed.
What is the most logical question that will come to your mind at this point? You will definitely want to know how much return you will get by the end of 5 years, right?
Do you really think there is a way you can actually calculate that? NO! You just cannot! Why so? That’s because you don’t really know how the interest rates are going to fluctuate during this 5-year period.
So, what is your most logical step now?
You will basically assume that if the interest rate stays fixed at say 8.75% per year for 5 years straight! With this assumption you will start calculating the growth rate or return rate at the end of 5 years.
So basically what you are doing here is that you are actually making a projection. You really cannot say how the interest rates will fluctuate in say, next 3 days! 5 years is way too long!
So, the compounded annual growth rate is just a projection of what you can get out of your investment for a certain period of time provided that the growth rate remains fixed!
This takes us to our next question…
In which context do we use it?
We have just learned that CAGR is a mere projected value. It is not real. So, where do we use it? Let us rule out a possibility first.
What about accounting?
Well, that’s the option we need to rule out. Why? That’s because in accounting, there is no such thing as projected value. In accounting, all that is accounted for are real values. So, accountants never ever make use of CAGR unless they want to make a comparison between the real growth and projected growth.
So, now that accounting is completely out of equation, we need to hunt for avenues where the concept of compounded annual growth rate is used.
Let us give you a slight tickle. Have you ever been approached by a mutual fund agent? What do they say? They keep saying – ‘we guarantee you so and so returns after 3 years or whatever’! Are they bluffing. Slightly yes! Actually mutual fund companies are pretty confident based on past experiences that they can deliver the promised growth rate. Their confidence comes from the fact that they actually diversify their investments between debt and equity instruments and hence, reduce the risks of losses significantly. This process is called risk mitigation.
But why are the agents slightly bluffing? Actually they shouldn’t use the word ‘guarantee’. They should rather say, ‘We are very confident that we will give you so and so returns but see, there are risks and hence, no guarantees!’
This will be a more honest statement because investments in market are subject to risks and there may be times when the market volatility really gets out of control, rendering all risk mitigation techniques completely useless. There are many examples where mutual funds have actually incurred loses.
Market is no one’s slave. In fact, we (all investors) are slaves of the market’s whims and wishes.
So, coming back to point, compounded annual growth rate or CAGR is usually used in fields of investments or in case of projecting business performances. In case of businesses, such projections are necessary to ensure that the company works towards achieving at least a partial growth, if not the full projection. Such projections actually help with business planning and even at times, such plannings help to design the whole work process.
Why is it necessary?
There is a simple answer to this question, which can actually be answered with a question. ‘Do you have an aim?’ Well, if you don’t have an aim, you go nowhere. If you have an aim, you end up at least somewhere which is better than nowhere.
Simply put, CAGR projection helps businesses and investments to come up with growth plans that are effective and time-tested.
How is CAGR calculated?
To be honest, there is no simple method of calculating this. You need to use a formula. What you really do is that you are actually calculating the rate of growth. Hence, you will need at least two values:
- The final value of investment that you want to achieve. You need to decide on this.
- The initial investment value. You will actually have this figure in real.
Once you have these two numbers, you will need a time frame (usually measured in number of years.
Once you have all these three values,
- Divide the final value by the initial value.
- Raise the resulting value to the power of the reciprocal of the time frame.
- From whatever value you get from step #2, subtract 1 and voila! You will have your compounded annual growth rate or CAGR.
Representing the three steps in an equation:
Isn’t that a lovely-looking equation? Okay, it isn’t and it is really boring but hey, that’s how the compounded annual growth rate is calculated and there is nothing you can do about it!
Hopefully we have managed to explain what CAGR really means and how it is calculated. In case you need some clarifications, feel free to drop a comment.