The compound annual growth rate, or CAGR, is one of the most precise methods for calculating and defining returns for an investment over a period.
The compound annual growth rate doesn’t represent the exact return rate; it should be viewed as a representational figure. So, the CAGR is a number that shows the rate at which an investment would have increased its value if it had grown at the same rate yearly. That’s assuming the earnings were reinvested at the end of each year. Some may argue that it’s unreal for an investment to grow at the same rate every year, and they will be right! The CAGR is usually used to smooth fluctuations of returns for a better understanding.
CAGR = ((value at the end / value at the beginning /) 1 / number of years – 1) x 100
Let’s say a random person has invested $10,000 in a stock portfolio with the following returns:
Let’s calculate the CAGR using the formula above.
CAGR = (($19,000 / $10,000 /) 1 / 3 – 1) x 100 = 23.86%
The compound annual growth rate of 23.86% over a three-year investment period allows an investor to evaluate past performance, compare options for capital, and make predictions for future investment value.