Investors looking to measure the return of their investment may find using CAGR a good tool to find the average yearly growth of this investment. It is base of the assumption that earnings are reinvested. The absolute annual return does not take into account the compounding so the CAGR is more accurate way to calculate yearly returns as reflects the consistent rate at which the asset has grown.
Formula to calculate CAGR
Example:
Let’s use an example where you have invested $10,000 into an asset for 4 years and after the 4th year the investment is worth $15,000. If we use the absolute return the formula below you would get 50%.
= Current market value – beginning market value) / beginning market value *100.
= ($15,000-$10,000)/$10,000 *100 = 50%
This absolute return figure does not take into the account the time which these funds were invested and the compounding in the asset.
Using the compound annual growth rate we would have {($15,000-$10,000)^ (1/4)} -1 = 10.67%
As investments may not generate the same return each year the CAGR gives you the average return of the asset per year assuming it grew the same rate each year. It also assumes returns are reinvested. This yearly figure can then be useful to compare to other yearly performance figures of other investments. The CAGR formula can smooth out the rate of return over the holding period which would make it easier for an investor to estimate the yearly rate of return and compare the performance to other assets.
Investors could also use the CAGR to determine what annual growth rate an asset should generate to accumulate a predetermined amount.
Lauren Hua is a private client adviser at Fairmont Equities.
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