What is CAGR & How to Calculate it?

There are different types of investment avenues in the market and each of these avenues promises you a compounded rate of growth if you remain invested. Compounding of return means earning a return on the return earlier generated. So, if you invest INR 100 and earn a return of 10% in the first year, the amount would become INR 110. Thereafter, in the second year, you would earn 10% on INR 110 giving you a return of INR 11. This compounding helps grow and multiply your wealth considerably over a period of time.

In the case of market-linked investments, the rate of return is not guaranteed. It varies over the investment period. To know the average rate of return on your investments, the concept of CAGR is used. Let’s understand what CAGR is and how it helps you find the growth of your market-linked investments.

What is CAGR?

CAGR’s full-form is Compound Annual Growth Rate. The Compound Annual Growth Rate, in simple terms, is the average rate of return of an investment over a one year period. CAGR takes into account two important factors - the time period of the investment and the fluctuations in the return. Since the returns vary depending on the market fluctuation, finding the return over a specific time period becomes difficult. CAGR gives you the average growth rate offered by the investment over the said time period. CAGR shows the approximate growth rate considering that there is no market fluctuation and that the returns earned are reinvested into the investment.

How to calculate CAGR?

It is very easy to calculate CAGR. There is a CAGR formula which you can use to find the Compound Annual Growth Rate of your investment. The CAGR formula needs three important details which are as follows –

• Value of the investment made initially (VI)
• Term of investment (T)
• Value of the investment at the end of the term (VE)
• Using these three inputs, the CAGR formula becomes – CAGR = (VE / VI) ^ (1/T) – 1
• Let’s understand with an example –

Mr. A invested INR 10,000 in a market-linked investment avenue. After 3 years, the value of his investments stands at INR 13,500. The CAGR for Mr.A’s investment could be calculated as below –

• VI – INR 10,000
• T = 3 years
• VE = INR 13,500
• CAGR = (13500/10000) ^ (1/3) – 1
• = 10.52%

How CAGR helps understand the mutual fund growth rate?

Mutual funds are market-linked investment avenues which do not offer a guaranteed rate of return. Since the returns are subject to market fluctuations, CAGR becomes an accurate tool to measure the performance of the fund over a specified period. Investors can check the annual CAGR of mutual fund schemes and use the rate to find out which scheme offers better returns than others. The fact sheet offered by the mutual fund house contains returns generated by the fund over different time frames. These returns can prove to be confusing and so CAGR is an easier alternative to understand the performance of the fund. CAGR acts as a ready reckoner for investors to assess returns from a mutual fund scheme and also highlights the compounding of returns on mutual fund investments.

• Important points to know about CAGR
• The investment risk inherent in the scheme is not highlighted by CAGR. CAGR is merely a yardstick to measure the growth rate

CAGR proves to be a good measure of growth for a short-term period, i.e. up to 6 or 7 years. If you are considering long-term investments, the growth trends over a short-term period would be averaged out. In such cases, CAGR would give an average rate even if the fund performed excessively well in a two or three year period and then the returns fell in later years.

CAGR changes every year since the investment period changes

CAGR for two investment funds can match one another even if the funds are different. This might happen if one fund performed well initially and the other one performed well in the last few years. As a result, the performance is averaged out and the CAGR

• Other modes of calculating returns from investments
• Besides CAGR, there are other ways to calculate the returns generated by market-linked investments. These ways are as follows –
• Returns since launch

Under this model, the return earned by the fund ever since it was launched and till the present date is calculated.

Trailing returns

Under the trailing returns approach, you measure the performance of your fund daily, weekly, bi-weekly, monthly or annually.

Annualised returns

Annualised returns are calculated as the geometric average of the return yielded by the fund over a given period of time.

CAGR v/s Absolute returns

Absolute returns measure the total return yielded by an investment. The time period is not considered. CAGR, on the other hand, measures the return over a specific time period. For instance, in the previous example, INR 10,000 grew to INR 13,500 over a 3-year period. The absolute return would be 35% since it measures the total return earned on the investment. However, when CAGR is considered, the time period of investments is also taken into consideration thereby considering the time value of money. As such, CAGR comes to 10.52% which is a more realistic figure. While absolute returns show the returns generated, the time period is missing. You cannot figure out how many years it took the investment to generate this return. But CAGR shows you the annual return making it easier to make a judgement on the performance of the fund.

The next time you invest in mutual funds, stocks or other market-linked investment avenues, consider their CAGR to choose the fund or investment which has better returns over its peers. So, visit IndiaNivesh and find out a mutual fund scheme of your choice and then compare the scheme’s CAGR with its peers to choose the best performing fund.

Disclaimer: Investment in securities market / Mutual Funds are subject to market risks, read all the related documents carefully before investing.