Compound Annual Growth Rate (CAGR) is a financial metric used to measure the growth of an investment over a specified period of time. It is a smoothed and annualized rate of return that represents the average growth rate of an investment over a certain period. It gives a more realistic picture of the investment’s growth rate by taking into account the effects of compounding over time.
The formula for CAGR is: CAGR = (Ending Value / Beginning Value)^(1 / number of years) – 1
Here, the ending value is the value of the investment at the end of the specified period, and the beginning value is the value of the investment at the start of the specified period.
Practical Examples of CAGR
- Investment in the Stock Market One of the most common uses of CAGR is to measure the growth rate of an investment in the stock market. For example, if you invested $10,000 in a stock five years ago, and its value has increased to $15,000, the CAGR would be calculated as follows:
CAGR = ($15,000 / $10,000)^(1 / 5) – 1 = 0.10 = 10%
This means that the investment has grown by 10% annually on average over the last five years.
- Retirement Planning CAGR is also used in retirement planning to determine the growth rate of a retirement account over time. For example, if you are saving $5,000 annually for your retirement, and after 20 years, your retirement account has grown to $200,000, the CAGR would be calculated as follows:
CAGR = ($200,000 / ($5,000 * 20))^(1 / 20) – 1 = 0.06 = 6%
This means that the retirement account has grown by 6% annually on average over the last 20 years.
In conclusion, CAGR is a useful financial metric that provides a more accurate representation of the growth rate of an investment over time. It takes into account the effects of compounding and gives a more realistic picture of an investment’s performance. Whether you are investing in the stock market or planning for your retirement, understanding CAGR can help you make informed investment decisions and achieve your financial goals.
