The percentage of an investment, in terms of it increasing and decreasing year over year, is determined with the financial investment calculation that’s known as CAGR. This stands for Compound Annual Growth Rate.
It can be compared with the annual average rate of return for a certain investment made by your company over a set period of time. As most annual returns of investments usually vary, the results of the CAGR equation are labeled as the returns of good and bad years – the latter two are put into one single return percentage that management and investors will analyze when making financial decisions.
The Basics of CAGR
While we said that the Compound Annual Growth Rate can be compared with the annual rate of return, you must remember that the two are not actually one and the same thing. The CAGR is an average that contains all of the annual returns that a certain investment has had as a result.
Moreover, in order to make the comparison between multiple investment opportunities, this equation evens the rates of all the years. This is because a company may not afford to lose an investment that could actually turn profitable.
For example, your company might make an investment that will lose money in the first couple of years, only to make a huge profit in the year that follows the losses. The CAGR evens out the bad years, so to call them – those that are likely to have negative returns – with the positive return of the following year.
The Formula of CAGR
In order to calculate the Compound Annual Growth Rate, you will first divide the Ending Investment Value by the Beginning Investment Value – this will have as result the total growth rate of the investment.
The result mentioned above is then taken to the Nth root, where N stands for the number of years in which your company has invested money in an investment. Then, to finish it off, you subtract one – this way, the result of the equation will show you the CAGR percentage.
Basically, this equation will firstly provide you with the total return of a certain investment, after which its second part – Nth root – will annualize the return over the life of the said investment. It’s quite simple once you get the hang of it.
Of course, as you have probably figured it out so far, the CAGR is there to compare multiple investments by looking at their returns. Moreover, the type of investment and the initially invested sum don’t matter – as this equation will help owners and managers get their money into places, as in investments, that have the highest possible return in the end.
Naturally, you don’t have to go heads-in in an investment just because the CAGR tells you that it is going to be profitable, especially if it is in unrelated activities. Doing so might lead to a suffering of production processes and losing customers and orders.
It’s already obvious by now – but the CAGR percentage should be as high as possible, meaning that the investment you chose must hold the highest return rate; that is if you want it to be a successful one.