Compound Annual Growth Rate (CAGR) is a measure of the average growth rate of an investment over a specified period of time. It represents the rate at which an investment would have grown from its beginning value to its end value if it had grown at a steady rate.
Applications:
- CAGR is used to calculate the average annual return of an investment over a period of time, such as stock market returns or the growth rate of a business.
- It helps in comparing investment options and in portfolio diversification.
Example:
Suppose an investment is worth $10,000 at the start of the year and $15,000 at the end of the year 5, then CAGR over 5 years would be calculated as follows:
CAGR = (15000/10000)^(1/5) – 1 = 0.1487 or 14.87%
Pros:
- It provides a single number that represents the average rate of return over a period of time, making it easier to compare investment options.
- It smoothens out fluctuations in the growth rate, providing a more accurate picture of the investment’s performance.
Cons:
- CAGR assumes a steady rate of growth, which may not be accurate in reality.
- It doesn’t account for fluctuations in the growth rate, so it may not accurately reflect the true performance of an investment over time.