Definition: The compound annual growth rate, also called CAGR, is the return on investment over a period of time. It measures a true return on an investment by calculating the year over year returns, compounding them, and considering the investment values. In other words, it’s a far more accurate way to measure the overall return on an investment than using an average returns method.
What Does CAGR Mean?
The compound annual growth rate formula is a bit complicated. The equation first divides the ending value by the beginning value of the investment. This gives you the total percentage of growth rate. It then computes the nth root of that rate where n equals the total number of years in the investment period. Then subtract one. It might be easier to actually look at the equation. Here it is.
As you can see, both the changing in value of principle and the compounding of interest over time is considered by CAGR.
Keep in mind that the compound annual growth rate is not the actual rate of return for an investment. It’s an annualized or composite number that shows what the rate of return would have been over if it was smoothed out and consistent over the life of the investment.
I know it’s kind of complicated. Let’s look at an example.
Let’s assume you put $5,000 into an investment today. A year from now it grew to $6,000. A year after that it grew to $6,500, and a year after that it grew to $7,500. The last year it was valued at $10,000. To calculate the CAGR, we first compute the change in value ($10,000 / $5,000 = 2). We can now take the percentage change in investment and adjust it to the power of the number of years in the investment period ( 1 / 4 years (.
So our finished CAGR example equation would be 2 ^ .25 – 1 or 2 to the .25 power minus 1.
The CAGR for the four-year investment would be 18.92 percent.