Roger Wohlner is a writer and financial advisor with over 20 years of financial services experience. He writes about financial planning for Wealthsimple and for a number of financial advisors. His work has been published in Investopedia, Yahoo! Finance, The Motley Fool, Money.com, US News among other publications. Roger owns his own finance blog called 'The Chicago Financial Planner'. He holds an MBA from Marquette University and a Bachelor’s degree with an emphasis on finance from the University of Wisconsin-Oshkosh.
An investment or an investment portfolio will experience different rates of return over different periods. For example, your portfolio might experience a large gain one year, a smaller gain the next year, and a slight loss in another year.
CAGR allows an investor to calculate their portfolio’s returns over a period of years: say, five years. It filters out the year-to-year “noise” in returns to help the investor figure out how their investments have done over a set period of time. This can be useful in helping them compare their results to other investments or a benchmark index.Wealthsimple Invest is an automated way to grow your money like the worlds most sophisticated investors. Get started and we'll build you a personalized investment portfolio in a matter of minutes.
How to calculate CAGR
The formula for CAGR is:
Divide the ending value of the investment by the beginning value of the investment for a certain time period.
Raise the value calculated in the first step by an exponent of 1 divided by the number of years you are calculating the CAGR for.
Subtract 1 from this result.
For example: The CGAR over a five-year period for a portfolio with a beginning value $100,00 and an ending value of $155,000 is 9.16%. (An online calculator can be used to do the calculation.)
IRR versus CAGR versus absolute return
It should be noted that none of these measurements are inherently good or bad, nor is one necessarily better than another. Rather, they are different, and these differences should be noted in deciding which measurement to use.
IRR stands for internal rate of return. This is a measure of return often used in the capital budgeting process by a company when looking the estimated return on their investment for a potential capital expenditure. An example might be an investment in a new manufacturing facility or an expensive piece of equipment.
The internal rate of return is a discounted cash flow analysis that uses the investment’s cash flows to calculate a discount rate that brings the net present value of the investment’s cash flows to zero. In plain English, the IRR calculation takes all of the investment’s anticipated cash flows and equates them to a rate of return. The IRR can then be used to compare various investment options to determine which ones are the best option for the company. IRR, like CAGR, is an annualized rate of return calculation.
This formula can be used by companies to determine where to best employ their capital for future investments in the business, by investors looking at various types of investments including financing a company or a project, or by someone looking at any sort of investment option.
Absolute return is simply the gain or loss of an investment at two points in time. In the example above the portfolio that had grown from $100,000 to $155,000 would have an absolute gain of 55%.
What’s missing is the time frame. In this example the time frame was a five-year period. It’s generally more helpful to look at average annual returns of some sort. This helps put things into a clearer perspective for most investors.
At the very least it’s prudent to do any comparison of the absolute return on an investment in comparison with another investment’s absolute return over the same time period.
IRR versus CAGR
Both metrics provide useful information. Here are some differences to consider.
CAGR just considers the beginning and ending values of the investment or the portfolio at the end of the appropriate period. IRR considers all of the investment’s cash flows such as the initial investment and any subsequent investments.
IRR can be used as an estimate of the potential return of traditional investments like stocks, bonds, and mutual funds. It is also a very useful tool in the corporate finance realm for looking at the potential returns on an internal investment such as a capital spending project.
CAGR looks at beginning and ending values. For an individual investment, cash flows such as dividends or interest will only be considered if reinvested back into the holding. If these distributions are taken in cash and then redeployed to another account or just spent, they would not factor into the CAGR analysis. This may be less of an issue if the calculation is being done on a portfolio and the cash that was distributed from various investment holdings was deposited in a money market account or other cash option that is part of that portfolio.
IRR is often done on a speculative basis. In other words, the project’s or the investment’s projected cash flows are used to calculate the IRR. These may or may not ultimately be the cash flows that are realized from the investment. CAGR is generally done after the fact when the results are known.
CAGR versus absolute return
There are some key differences between these two methods of calculating returns on an investment or a portfolio.
Absolute return is the total return of the investment or the portfolio from point A to point B in time. It doesn’t take annual time periods into account, nor does it consider the cash flows from the investment or the portfolio over the holding period.
This view that only includes the change in value over two points in time does not consider the volatility of the annual returns on the investment.
Applications of CAGR
CAGR can have a number of applications for investors. Remember, CAGR is not a true return calculation, but rather a way to look at the annualized growth rate of a portfolio or an individual investment over a period of time. CAGR can have a number of applications for investors and others.
Note that neither CAGR or any other similar methodology for looking at the actual or potential return on an investment can forecast the future.
CAGR can be an excellent way to compare two investments. Perhaps you are looking two mutual funds with different levels of annual volatility. Looking at their CAGR over the time period can help provide a longer-term perspective on the two funds. It smooths out short-term fluctuations between the two investments and can show how they perform over longer periods of time such as three years, five years, or whatever timeframe is meaningful to the investor.
The caution here is that volatility shouldn’t be ignored and CAGR is not the right measurement tool to alert investors to the shorter-term volatility of an investment. While being a long-term investor is a good goal, human nature might make it tough to stomach downside volatility in an investment, especially during a broad stock market or economic correction of the nature that we saw during the financial crisis of 2008.
Looking at future goals
Another way that investors can use the CAGR calculation is in helping determine what type of annual returns they might need to achieve a goal. Saving for college or retirement could be an example. This tends to work best with a lump-sum invested and then held for a set period of time.
In the case of college, if you had a lump-sum of $20,000 and were looking for that to grow to $80,000 over the next 15 years, you would need to achieve a CAGR of 9.68%. This gives the investor a starting point in deciding how to invest this lump sum. They can look at various investment options such as ETFs, mutual funds, individual stocks and others that might help them achieve this goal individually or as part of a portfolio.
Taking this further, they might look at this college account each year to recalculate the CAGR needed to achieve their goal. For example, if they have several outstanding years with investments, perhaps they want to relook at their investment mix in light of what would likely be a lower required CAGR to achieve their goal.
Again, CAGR could be a part of this process, but they would be wise use other metrics as well. And of course, their risk tolerance should play a role in the process as well.
Limitations of CAGR
As mentioned previously, CAGR has some limitations as well.
Two points in time
CAGR is a return measurement of an investment over two points in time. It ignores any cash flows or volatility that may have occurred in the interim. It essentially smooths out the investment ride, so to speak.
CAGR by itself can be deceiving and might not provide the true answer the investor is seeking in doing the analysis. CAGR, combined with other metrics and analysis tools can help provide an investor with good picture of investments or portfolios they may be considering.
The past is not an indication of future performance
No matter how favorable a picture a CAGR analysis might paint, the adage that past performance is not an indication of what might happen in the future holds true. The CAGR for a stock might look stellar, but an investor needs to look further to decide if that company constitutes a good investment.
An investor needs to look at the company, mutual fund, the ETF or the portfolio they are considering and decide if it is positioned to prosper going forward. In the case of the company, is its product or service likely to remain in demand? Is the management team considered solid?
In the case of a mutual fund, what are the expenses? Is the manager who guided the fund to its solid past track record still in place (in the case of an actively managed fund)?
The bottom line
Like any return calculation or other metric, CAGR is useful, but is more useful if considered as part of a larger overall analysis.