Why CAGR is Important
Understanding Compound Annual Growth Rate (CAGR) and Its Importance
The Compound Annual Growth Rate (CAGR) is a fundamental concept in finance. It indicates the average growth an investment has registered on a yearly basis over a given duration, considers profit reinvestments accrued at the end of every year. Unlike simple averages, CAGR considers the compounding effect, portraying an investment’s performance accurately. The formula is stated as follows:
CAGR = (EV/BV) 1/n- 1
In the formula, EV is the ending value, BV is the beginning value, and n is the number of years.
Why is CAGR Important?
CAGR is important because it enables investors to make comparisons between differing investments that have different time intervals and returns. CAGR standardizes the way performance is measured, providing convenience. It smoothens the extreme fluctuating values for an asset’s annual returns, thus clearly depicting consistent growth. This is specifically useful when understanding the long-term investments made in stocks, real estate, mutual funds, and business.
When Should CAGR Be Used?
CAGR is better utilized when analyzing the historical growth trend of a certain investment over a duration of multiple years. Thus it aids in strategic financial planning. It is relevant for:
1. Comparing Investment Options: Investors apply the use of CAGR in determining better long-term growth between several selected mutual funds, stocks, funds, or portfolios.
2. Creating financial objectives: With the help of a CAGR, one is able to estimate how much an investment will be worth in the future which greatly assists goal oriented financial planning.
3. Measuring the success of a business: Companies use the CAGR in measuring the increase in revenue, profits, or market shares of a company over a period of time.
Nonetheless, the lack of analysis of intra-year volatility and market fluctuations makes CAGR less useful on its own. As a result, it must be used in conjunction with other measures such as standard deviation or rolling returns.
