Last edited 10 Nov 2020

Compound Annual Growth Rate (CAGR)

Compound annual growth rate (CAGR) is a measure of the mean annual growth rate of an investment over a specified time period. It measures the growth rate effecting the value of the initial investment to that of the end-of-period investment, with the assumption that over that time period the investment has been compounding.

While CAGR isn’t a true return rate, it is a representational figure used to understand an investment’s returns and is considered a better measure of return over time. The effects of compounding are ignored by the average annual return figures, which can overestimate an investment’s growth. By contrast, CAGR uses a geometric average to represent the consistent rate at which, if compounding had occurred at the same annual rate, the investment would have grown.

The formula for CAGR is:

CAGR = (EV / BV)^(1 / n) - 1

where:

EV = Investment's end-of-period value
BV = Investment's beginning value
n = Number of periods (months, years, etc.)

As an example, if an investment of £2,000 is made for six years, with year-end values of the investment as follows:

Year 1: £1,500
Year 2: £2,000
Year 3: £6,000
Year 4: £8,000
Year 5: £10,000
Year 6: £12,000

The CAGR is: (12,000 / 2,000)^(1/6) – 1 = 0.348 = 34.8%

As it is a simple metric, CAGR is also flexible and can be used in a variety of ways, for example, comparing investments of different types, or tracking the performance of various measures alongside one another.

However, it should be used with other metrics to give a representative overall picture as it does have some limitations. For instance, it ignores volatility and implies that growth over the time period was steady, whereas in reality growth can be higher or lower from one year to the next. In addition, CAGR does not predict that the investment will continue to grow at the same rate, as it is only a historical metric. Many other factors might affect the rate of growth in future years.