For the most part, the decisions made within the financial ecosystem are backed by an exhaustive study, in order to achieve more profitable investments and minimize losses. For this reason, there is a wide variety of formulas and terms that help professionals in the field to understand the growth and development of businesses. However, for people outside this environment, these formulas can become complex and confusing, inhibiting them from using them to improve their investment strategies.
In this way, to offer a little clarity about this ecosystem, we wanted to explain one of the most used formulas within the investment landscape: the CAGRfor its acronym in English, or Compound annual growth rate (CAGR).
What is compound annual growth rate?
As its name indicates, the CAGR is a percentage term that indicates the annual growth of an investment process. Namely, allows to know the rate of return of an investment in a certain period of time, which is always greater than one year. Said rate of return is applicable to both fixed income and variable income investments.
One of the main characteristics of this indicator is that it allows the measurement of the return on investment in a smoothed manner. Which means that mitigates market volatility, offering a result based on a linear situation and without major changes. With this, the CAGR/CAGR allows knowing if the average of an investment has been positive or negative, helping to determine future actions.
That said, the result obtained provides a very simple approximation of the investment results. Thus, it is always recommended to use it in conjunction with other more complex formulaswhich include different variables, and offer a result closer to reality.
Either way, calculating the compound annual growth rate is really easy once you understand its components. In the first instance, it is necessary to obtain the initial value of the asset, and the final value after the determined period of time, and then divide the final value by the initial value. Once this is done, the result must be raised to the first power divided by the number of years to be evaluated, and then subtract one (1) from the result obtained. In short, the formula would look like this, where “n” equals the number of years to evaluate:
- (Final Investment Value/Initial Investment Value)^(¹/ⁿ) – 1 = CAGR/CAGR (%).
We see it with an example, if the initial value of the investment is 10,000 euros and the final value, after three years, is 20,000 euros, we would have that the CAGR/CAGR is: (20,000/10,000)^(⅓) – 1 = 26%
Another aspect to highlight is that this result is compound, so it takes into account the revaluation of the investment year after year. In other words, it always takes into account the revaluation of the previous year in the calculation of the following year. For the previous example, it is intuitive to think that the annual return on capital in 3 years is 33%.
Why is CAGR/CAGR so important to the investment industry?
As we have seen, the main use of this formula is to estimate the percentage return on an investment in a given annual period. Knowledge of this indicator thus allows investors to take into account possible ways to continue with their investments, based on their performance.
For example, if the calculation of a current investment results in a negative result, it is likely that a reinvestment will not be made. This is due to the fact that its performance does not offer profitability to the investor, generating losses.
Currently, the investment landscape in Spain has been very active, especially within the emerging ecosystem of startups. Therefore, the management and knowledge of these indicators is considered a considerably useful tool.
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