It is the ratio of returns required to grow an investment from its initial balance to its final balance, assuming that profits are reinvested at the end of each year of the investment’s life. It is often used to measure and compare the past performance of investments or to forecast their future returns.
Compound annual growth rate
The compound annual growth rate is calculated using the following equation:
Compound annual growth rate = (1 number of periods) -1 (final value initial value).
Compound annual growth rate applications
The compound annual growth rate is used to:
- Calculate the average growth for each investment separately.
- Comparison of different investments.
- Monitoring the performance of work standards in one company or several companies together.
- Explore strengths and weaknesses by comparing its activities with those of other companies.
- An investor benefits from understanding the CAGR as one of several ways to assess past returns or estimate future earnings. Some algebraic operations can be performed on the equation in order to find out the present or future value of money or to calculate the marginal rate of return.
Compound annual growth rate Features
- Accurate method of calculating past returns.
- Compare the relative performance of an investment.
- Estimate the expected future returns or set it as an attainable goal.
Compound annual growth rate disadvantages
- The profitability of the investment is not computed with the marginalization of the inflow and outflow during the investment period.
- It does not account for investment risk.
- It is assumed that there is a constant growth rate over the investment period.
Read also: What are capital markets?
