Compound Annual Growth Rate (CAGR)
CAGR is defined as the hypothetical constant annual rate at which an investment would have grown from its beginning value to its ending value over a given time horizon, assuming profits were reinvested at the end of each period.
Formula
CAGR = (Ending Value / Beginning Value)^(1/n) − 1
Where n is the number of years.
Why CAGR Is Useful
Actual investment returns fluctuate year to year. CAGR smooths out this volatility to provide a single, comparable figure. This makes it particularly useful when comparing the historical performance of two different mutual funds, asset classes, or instruments over the same period.
For example, if one fund grew at 12% in Year 1, declined 5% in Year 2, and grew 18% in Year 3, calculating the simple average (8.3%) would overstate actual wealth creation. CAGR accounts for the compounding effect and provides a more accurate picture of annualised growth.
Limitations
- •CAGR does not capture intra-period volatility. Two investments may have the same CAGR but very different risk profiles.
- •It assumes a straight-line growth path, which rarely reflects reality.
- •CAGR is not applicable when evaluating investments involving multiple cash flows at irregular intervals — XIRR is more appropriate in such cases.
- •Past CAGR figures do not indicate future performance.
Common Applications
CAGR is widely used in mutual fund factsheets, stock market analysis, company revenue comparisons, and fixed deposit return illustrations. SEBI regulations require mutual funds to disclose performance using CAGR for periods exceeding one year.