In the financial world, the term CAGR is used very commonly to describe the growth of a particular investment. I am sure you must have read something like this:

Machine Learning Market to exhibit 38.6% CAGR till 2028

But many don’t actually understand what exactly does it mean?

After reading this blog post till the end, I assure you that you will not be confused any more and you will clearly understand the concept of CAGR.

Following is the definition I would like to quote — Don’t worry if you didn’t understand this completely for now, I assure you if you read it again after completely reading this blog then you will understand it completely.

CAGR tells you how much growth your investment has given you each year. CAGR is the rate of return required for an investment to grow from its beginning balance to its ending balance, assuming profits were reinvested at the end of each year of the investment’s lifespan.

Before explaining CAGR, I would like to tell you other methods to calculate return.

Assume that you have invested Rs. 10000 for 5 years. This is how your money has grown every year:

First, I would like to talk about Absolute Returns (%).

Absolute Returns (%) = ((FV – IV)/IV)*100 = ((16000-10000)/1000)*100=60%

This doesn’t tell us how much on an average we gained per year. For that we take Simple Annual Returns (%).

This tells us that we have earned 12% every year but it doesn’t actually tell us how much money has grown.

As you can see from the image above, money growing at 12% every year for 5 years is 17623. This amount is incorrect because our actual amount is 16000. This is because this 12% is calculated on the principal amount without considering annual profits.

I.e. if you add 1200 (12% of 10000) every year for 5 years, then you will get 16000.

This is where CAGR comes into picture. It tells us how much our money has grown every year.

The formula to calculate CAGR is:

Putting the values, we get:

CAGR (%) = 9.86%

Now you can see from the image above that 9.86% of each year’s amount for 5 years gives us 16000, which is correct!

Hence, our investment of 10000 has given us return of CAGR 9.86% for 5 years.

I hope that by comparing different types of methods to calculate Returns, you would have understood CAGR. In case you still have any doubts, comment below.

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