What is CAGR and How Is It Calculated?

CAGR is the average annual rate at which an investment grows over a specific period. It assumes that:

• All gains earned during the investment period are “reinvested”

and

• Continue to generate returns in the following years

Instead of showing the return earned in each individual year, CAGR expresses the overall growth as a single annual percentage. For example, 

• Suppose you invest ₹1,000, and the CAGR is 10% after 5 years. 
• Now, the actual returns during these five years may have been different every year. 
• One year the investment may have earned 15%, another year 6%, and another year even a negative return. 
• However, since the CAGR is 10%, it means your investment grew at an “average” annual rate of 10% over the entire five-year period.

Note that the CAGR does not show the actual return earned in each year. It only represents an average yearly growth rate that would take the investment from its starting value to its ending value over the investment period. Therefore, CAGR is usually termed as a calculated or “estimated” annual growth rate. 

Since you now know about the CAGR meaning, let’s move forward and see how to calculate it. Mathematically, CAGR is calculated using the following formula:

Where:

• Beginning Value = The amount you initially invested.
• Ending Value = The value of your investment at the end of the investment period.
• n = The total number of years the investment remained invested.

The above formula calculates the annual rate at which your investment would have reached its maturity or final value over the given time period. For more clarity, let’s study a hypothetical example.

Example of CAGR Calculation

Suppose you invested ₹1,00,000 in a mutual fund. After 5 years, the investment potentially grows to ₹1,61,051. Now, we can calculate the CAGR by applying the above formula:

So, the CAGR is 10%, which means that although the mutual fund's returns may have varied from one year to another, the investment grew at an average annual rate of 10% over the five-year period (assuming all gains remained invested).

Absolute return shows the total percentage by which your investment has increased or decreased from the time you invested until you redeemed it. It only compares the initial investment amount with the final value and does not consider how long the investment remained invested.

For example, 

• Suppose you invest ₹1,00,000, and after 5 years, its value becomes ₹1,50,000. 
• The investment has increased by ₹50,000, so the absolute return is 50%.
   

In comparison, CAGR takes the investment period into account. It calculates the average annual growth rate required for the investment to grow from its initial value to its final value over a specified number of years. 

In the above example, although the total return is 50%, the CAGR is approximately 8.45% p.a. ]. For a better understanding, let’s study the detailed comparison below:

So, now you know the CAGR full form, its meaning, and how it is calculated. If we were to revise, the CAGR full form in mutual funds is “Compound Annual Growth Rate”. It is a return metric that calculates the average annual growth rate of an investment over a specified period, assuming that all profits or gains are reinvested instead of being withdrawn.

To calculate CAGR, you may use the CAGR formula, where you need to input these three measures:

1. The beginning value or original amount invested
2. The ending value or the maturity amount
3. The investment period (n)

Further, realise that the CAGR differs from absolute return, which shows the total percentage gain or loss over the investment period (ignoring the investment duration). In comparison, the CAGR factors in the time period and calculates the average yearly growth rate. Usually, it is the preferred metric for evaluating long-term investment performance. 

For more information, you can visit www.tatamutualfund.com/deshkarenivesh. The Investor Service Centre of Tata Asset Management Pvt. Ltd. is located at Mulla House, Ground Floor, 51, M.G. Road, Near Flora Fountain, Mumbai – 400 001, Maharashtra. The office hours are Monday to Friday, 9:00 AM to 5:30 PM. For assistance, you can also call (022) 6282 7777 from Monday to Saturday, 9:00 AM to 5:30 PM, or email service@tataamc.com

1. Is a higher CAGR always better when choosing a mutual fund?

As per general industry understanding, a higher CAGR may indicate that the mutual fund has delivered a better average annual growth rate over the selected period. 

However, it should not be the only factor for making an investment decision. You may also consider the following:

• Fund's risk level
• Performance across different market conditions 
• Portfolio quality
• Expense ratio
• CAGR generated by industry peers, and more

2. Can CAGR be negative in mutual funds?

Yes, if the value of your investment falls below the amount you originally invested, the CAGR could be negative. A negative CAGR indicates that the investment has lost value over the selected period and represents the average annual decline in your investment's value.

3. Should I use CAGR to calculate SIP returns?

As per general industry practice, CAGR is not suitable for calculating returns generated by SIP investments. That’s because each SIP installment is invested on a different date. 

Since every investment remains invested for a different duration, CAGR may not accurately measure the returns. For SIPs, XIRR (Extended Internal Rate of Return) could be the more appropriate return metric.