Compound annual growth rate (CAGR): What you should know

Many of us take a “set it and forget it” approach to investing, but keeping tabs on your finances can pay off in the long run. One great way to do that is by calculating the compound annual growth rate, or CAGR. Keep reading to learn how to calculate your investments' compound annual growth rate to have more control over your financial future. 

What is CAGR in simple terms?

The Compound Annual Growth Rate (CAGR) is a number that shows the average annual growth rate of an investment over a set period, assuming steady growth each year. While actual investment returns may fluctuate yearly, CAGR smooths out these variations, combining them to show the average overall growth rate to get to the final result.

Think of it like figuring out your average gas mileage after a trip. You went faster on the highway and slower in the cities, but you just need to know how many miles per gallon you averaged throughout the trip. CAGR is the "miles per gallon" of your investments. If $1,000 grows to $1,331 over 3 years, the 10% CAGR tells us the investment effectively grew by 10% each year, even if the actual growth varied year to year. 

Importance of CAGR in finance

Compound interest accounts can be one of the more reliable, time-tested ways to build wealth or save for retirement. To make an informed financial or retirement plan, you need to know how your accounts perform — that's where CAGR comes in. Using CAGR allows you to measure investments with a common calculation to compare which are growing well and which are lagging. With compounded interest, the earlier you invest, the longer your money has to grow, so it's essential to stay on top of your investment performance. 

How to calculate compounded annual growth rate

The ability to determine CAGR can help you make more strategic investments now and in the future. Here’s how:

Basic formula

Be a financially smart family!

Be a financially smart family!

From saving for the future to understanding credit, see how families are thriving with Greenlight.

Try Greenlight today

To find a CAGR, you'll need to follow the following formula: 

CAGR (%) = (Ending Value ÷ Beginning Value) ^ (1 ÷ Number of Periods) – 1

So, if you start the investment period with $1,200 in a mutual fund and the account is worth $1,500 three years later, you would have a CAGR of about 7.6%. Why? Because when you divide the ending value ($1,500) by the beginning value ($1,200), you get 1.25. 

Next, you'll divide one by the number of investment periods (three years) to get .33. Then, you will raise 1.25 to the .33rd power and subtract one. This results in the awkward decimal 0.0762, which you can convert to the CAGR of 7.62%.

Step-by-step calculation

This complicated process becomes less convoluted when we break it down step by step. 

1. Identify the values: Start by gathering your revenue growth statements. Identify the current and initial value of the accounts, plus the period you want to assess. 

2. Divide the current account value by the initial account value. 

3. Now, raise the number from step two by one minus the power indicated by your investment period. So if you invested for three years, you'll divide one by three, yielding .33. 

4. Subtract one from the number yielded in step three. 

5. Convert the decimal to a percentage by multiplying the number by 100. 

Interpreting CAGR

Fortunately, interpreting CAGR is a bit more straightforward than calculating it. Let’s look at how to use CAGR to seek better rates of return. 

Assessing investment performance

You can use CAGR to compare your investments and redirect future deposits to better-performing options. For instance, if you’re planning your retirement and notice one mutual fund has a CAGR of 2% while another weighs in at 7.5%, consider reallocating future investments to the higher-performing fund. 

Remember, the earlier you invest, the better off you’ll likely be over the long term. 

Comparing different investments

You can also use CAGR to compare investment types like stocks, mutual funds, bonds, or real estate. Calculating the CAGR lets you compare these diverse investments using a like set of numbers, so you aren't comparing apples and oranges.

If you’ve got those old math books around, dust them off and refresh your memory of standard deviation. Calculating standard deviation can also help you compare investments effectively. 

Tracking business growth

Likewise, you can use CAGR to calculate the profits of a business over a set period using the beginning and end value of the company plus the number of years you hope to measure. 

You can assess business finances in many ways, but CAGR focuses specifically on the company's growth in value over a given date range. 

Why is this helpful? Finding the compounded average rate per year helps you spot and contextualize anomalies that may pop up one year but not the next. 

What is the CAGR formula in Excel?

If you're working in Excel, you'll use the XIRR function to calculate CAGR. This function calculates internal rates using a schedule that is not necessarily periodic. In other words, once you use the XIRR function, you'll be able to pull values directly from different cells to help you calculate the compounded annual growth rate that matches your preferred investment period.  

What is the difference between CAGR and growth rate?

Growth rate and compounded annual growth rate differ in a couple of important areas. First, CAGR tells you the average growth per year, while growth rate tells you the revenue growth over that full investment period. That's why CAGR is often called a "smooth rate," as it smooths out the variance. 

However, using only CAGR can impede risk assessment. By smoothing out variance, a CAGR alone can make it difficult to account for short-term volatility since you’re eliminating those small peaks and valleys.  

Second, while the growth rate is typically used in short-term assessments, CAGR is most useful for long-term analysis. A growth rate calculation can be helpful for year-to-year or quarter-to-quarter, while CAGR looks at periods beyond three years. 

Use of CAGR in financial forecasting

You can use CAGR calculations for financial forecasting to prepare for the road ahead. Some people use CAGR to anticipate future business revenue. Others use it to project market size, allocate investments, or even guess real estate trends. It's important to remember that past performance is the best indicator of future rate of return, but nothing is guaranteed. 

Analyzing historical returns with CAGR

When you're trying to decide the best place to let your money grow, analyzing historical returns using CAGR gives you helpful data to make investment choices. 

Let's say you want to invest in a big box store. When you pull the historical analysis for different companies, you see that one company has a CAGR of 5% over the past five years while the other has a CAGR of 3%. Knowing the difference can help inform your investment opportunity. 

Practical examples of CAGR calculations

Here are some real-world examples.  

Example 1: Investment growth

You invested $3,000 in a small market mutual fund about 12 years ago, with instructions to reinvest profits you earned. Now, your mutual fund holdings are worth $7,800, giving you a compounded annual growth rate of 8.28%. If you were to change jobs or investment strategies later, knowing the CAGR helps you decide whether to reinvest those funds in your new retirement account or keep them where they are.

Example 2: Business revenue growth

A small business called Terry's Tissues was worth $300,000 about seven years ago, but after expanding into new markets, the company is now worth $1.5 million. For this company, the CAGR is about 25%. That's nothing to sneeze at. 

Key takeaways: Understanding and using CAGR in finance

When you understand the compounded annual growth rate and use it to assess your investments, you can set yourself up for better financial returns by dumping the laggers and boosting the winners. Better understanding can often lead to bigger profits.

As you invest in your family's future, you can also offer learning opportunities for your kids. The Greenlight investing app teaches kids the basics of investing and lets them see their money grow ... with a little help from you. Try Greenlight today