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Scholasticus K
Jun 22, 2019

For any person who has invested money, it is essential that he evaluates his investment performance. Hence, it is important to calculate the total return or Compound Annual Growth Rate (CAGR). The method of calculation and the associated concept has been discussed here.

Compounded annual growth rate (CAGR) is defined as the growth rate of investment, expressed in percentage. It is principally used in cases where the initial and final investment amount is known. It is applicable to fixed return investments such as annuities and insurance policies where the return amount is assured.

Its formula is not applicable to investments that tend to have a floating returns structure, as the portfolio performance is governed by market conditions. However, there are instances where the formula and final percentage rate are needed, in order to analyze and assess the said investment.

It takes into consideration three important values or dimensions of a specified investment: the ending value, the beginning value, and its time period. The end result of this formula is a rate (expressed in percentage) that gives us the ROI received per year.

CAGR = {(Ending value / Beginning value)(1 / no. of years)} - 1

The formula will give you a percentage rate that is applicable for every year, in an annualized manner. Plug in the three values and compute your investment's growth rate.

The formula will give you a percentage rate that is applicable for every year, in an annualized manner. Plug in the three values and compute your investment's growth rate.

This rate concept is applicable in several circumstances where the 3 requisite numbers i.e. the ending value, beginning value, and number of years are available. Though, in theory, the formula is applicable to fixed return investments, you can use the same to analyze, summarize, and forecast the return value on an annual basis.

Thus, right from stock investments to mutual funds and index funds, it can be used as an analyzing tool. There are two potential ways in which we can apply it: before investing into a said channel, and when you want to derive the rate of return for a year.

In such a case, if it is a fixed return investment, then the CAGR points out to your return in the coming years. If the investment gives a variable return, then the formula can be used to predict it.

In such circumstances, where the portfolio determines the returns, the percentage value is the ideal rate of return that one might receive, and the product in such a situation is more of a guideline. In several cases, the CAGR is used post-investments to derive your earnings and its rate.

Thus, the formula is a very useful tool that helps in financial planning, management, and deriving the best investments. Though not an accounting concept, it can be used for multiple purposes.