By definition, Compounded Annual Growth Rate (CAGR) is a geometric mean that represents the constant rate of return over time, of a specific unit in business or investment.
It’s not a term officially used in Accounting, but it is nevertheless useful when it comes to analyzing performance against benchmarks, and comparing growth rates of similar entities.
If you did not understand one word of that definition, then don’t worry. Here’s the layman’s explanation of CAGR.
Imagine you placed P100,000 in a time deposit with an annual interest rate of 1%. After 1 year, that P100,000 will earn 1% interest or P1,000 – giving you a total of P101,000 (let’s ignore the taxes to simplify the computation).
But you don’t want to get your money just yet, so you “roll-over” your time deposit for another year. At the end of Year 2, your P101,000 will again earn 1% interest or P1,010 – giving you a total of P102,010.
The cycle goes on… where every year, your time deposit earns 1% interest on top of its current value.
That 1% – is the Compounded Annual Growth Rate (CAGR) of our time deposit.
So to put it simply, the CAGR value tells how much your investment is growing every year, and is written as a percentage rate.
To calculate for the CAGR, divide the Ending Value (EV) by the Beginning Value (BV), and then raise the quotient to one over the number of years (N) of the time period, and finally subtract one to the result. The following is the mathematical formula, which is easier to understand:
CAGR = [ ( Ending Value / Beginning Value ) ^ ( 1 / number of years ) ] – 1
If you have a calculator with you (I’m sure you have a smartphone), then you can test our time deposit example above. Let’s apply the formula above part by part:
First part of the CAGR Formula:
Ending Value / Beginning Value = P102,010 / P100,000 = 1.0201
Second part of the CAGR Formula:
(1 / number of years) = (1 / 2 years) = 0.5
Third part of the CAGR Formula:
[ (1.0201) ^ (0.5) ] = 1.01
Last part of the CAGR Formula:
[1.01] – 1 = 0.01 = 1%
It’s easy to calculate CAGR if you take it part by part, and you can do with a scientific calculator, or even Google.
Why Knowing How To Compute The CAGR Matters
I use CAGR for two basic reasons. First, to see if an investment is doing good.
By personal observation (and not based on anything else), I noticed that the CAGR of investments with respect to their risk profile, falls between these ranges:
- Low-Risk Investments (less than 3 years): 1% to 4%
- Moderate-Risk Investments (between 3 to 5 years): 4% to 12%
- High-Risk Investments (more than 5 years): 12% to 18%
So if an investment falls below the range, then it means it’s not performing well. But if it falls above the range, then it’s actually doing good as an investment.
For example, Jollibee (JFC) stocks was P50 back in 2008, while today, after 5 years, its price is around P180. By applying the formula, the computed CAGR will be 29.20%.
The stock market is a high-risk investment, so this means that JFC stocks getting a CAGR of 29.20% after 5 years means quite an excellent performance.
Another example is Ayala Land Inc. (ALI) stocks which was P7 back in 2008. It’s now around P28.50, which gives us a CAGR of 32.42% – that’s excellent annual growth that even outperformed my favorite stock, JFC.
Lastly, let’s take the stock of Centro Escolar University (CEU) which was selling at around P6 per share back in 2008. Now, it’s selling at roughly P11.30 to give you a CAGR of 13.5%
While CEU fell within the range, it’s growth can at best, be described as “expected”. This means investing in CEU stocks is not good for capital growth. However, CEU regularly gives out cash dividends, so it’s actually a good source of passive income.
The second use of CAGR for me is to compare the performance of different types of investments.
If you were to ask me today which one is a better buy, JFC or ALI, then I would say, “ALI because it grew faster historically in the past five years.”
I could likewise use this to compare the different types of UITF’s and mutual funds, to help me see which investment fund performed quite well in the past.
Don’t Fall Into The CAGR Trap
The Compounded Annual Growth Rate of an investment is just one factor you can consider when deciding where to invest. Your objectives and risk tolerance should actually come first.
Also, do not compare the CAGR of two investments with different risk profiles. It’s not fair to say that time deposits (zero-risk) are poor investments because its CAGR is just 1%, compared to ALI stocks (high-risk) with 32.42% CAGR.
So remember, always compare the CAGR of investments with similar risk profiles. Or just use the benchmark range I gave above, which is taken from personal observation as an investor in the past 10 years.
CAGR is a tool, which can help you “break the tie” when you can’t choose between two or more investments. But it should not be your primary nor your only consideration when doing investing decisions.
The CAGR value gives you the average growth of an investment year per year. And it’s good to use for two reasons:
- To see if your investment is growing at par with historical average rates
- To compare two or more similar investments, and see which one performed better in the past
I hope you were able to understand today’s investing lesson. If not, don’t hesitate to leave your question in the comments section below.
If you’d like to receive more of these type of articles that helps you become a better investor, then please subscribe to Ready To Be Rich. Thanks.
SELECT AN ARTICLE TO READ NEXT BELOW: