The compound annual growth rate can be defined as a measure through which the growth over multiple periods of time can be measured or estimated. This is the growth rate that provides you with the idea from the initial investment to the ending investment if the investment is compounded over the period of time for which the investment is being made.
Formula of Compound Annual Growth Rate
CAGR = (EV / BV) 1 / n – 1
EV = Investment’s ending value
BV = Investment’s beginning value
n = Number of periods that can be number of months, number of years etc.
In order to understand the concept of compounded annual growth let’s take an example of an individual who invested an amount of $1000 in a fund for a time period of five years.
Year Ending Value
1 $ 750
We can calculate the CAGR of the investment as:
CAGR = (5,000 / 1,000)1/5 – 1 = .37973 = 37.97%
Importance of Compounded Annual Growth Rate
Although in most of the cases return of the mutual funds is measured through average annual return but CAGR provides a better picture of the return of the investment over a specific period of time. The problem with annual rate of return is that it ignores the effect of compounding that may result in over estimation of the return of the investment over period of time. On the other hand compounded annual growth rate is the geometric measure of the rate of return of the investment over the period of time that provides us with a consistent rate of the growth of the investment if it is being compounded at the same rate for each year of that specific time period.
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