What is CAGR?

I suppose the first thing that you need to know about CAGR is what it stands for. And no, for all you feline enthusiasts, it does not mean 'Cats Are Great, Really'.

In fact, the very important acronym stands for:

Compound Annual Growth Rate

If you are an investor, then this is definitely a word you will have heard a lot and one you definitely need to understand. So what does it mean?

What does CAGR mean?

You will have seen earnings reports or company profiles that refer to a companies CAGR, for example:

Apple's (NASDAQ: AAPL) five-year revenue CAGR is 7.3%, or that Tesla (NASDAQ: TSLA) has a five-year CAGR of 50.4%.

As the name suggests, this is simply referring to the growth rate of Apple and Tesla's revenue over the course of five years. So in that vein, Apple's revenue grows, on average, 7.3% per year, and 50.4% for Tesla.

While this refers to a company's revenue growth, CAGR can also refer to the growth of an investment in specific stocks. It is often used to measure and compare the stocks past performance of investments, or to project their expected future returns.

In short: CAGR it is a mathematical formula that provides you with an idea of how much an investment will yield on an annual basis.

How does CAGR work?

Without going into too much detail, and thus proving my complete lack of understanding of basic math, you calculate CAGR by taking the Nth root of the total return, where N is the number of years you held the investment. If you're a bit of a maths wizard, you can toy with the formula below:

CAGR = (1+Growth Rate)^(365/Days)-1, where (End Value / Start Value)=(1+Growth Rate) and (1/Years)=(365/Days).

However, if like me, you can barely calculate your birthday, and just want to know how much money you'll make from a specific investment at a set CAGR, we have a wonderful calculator right here, just for investors.

Why is it important?

As the market is a volatile beast at times and damn near impossible to predict, there is no way of knowing exactly how one investment will pan out. If we could do that, then everyone would just have invested in Amazon (NASDAQ: AMZN) or Netflix (NASDAQ: NFLX) the minute they IPO'd, and then sailed off into the sunset with their gold-plated yachts.

However, CAGR does give a representational figure for an investment that can give some knowledge as to how much their investment will yield in returns. Going back to the Apple example from above:

Should you buy one share in Apple today (April 7, 2020) at $262.47, at its current CAGR, you can expect that share to grow by approximately 7.3%. Theoretically, the share will be worth $281.63 in 365 days.

Is CAGR accurate?

Of course, this is rarely exactly accurate over 12 months, as that 7.3% figure represents an average growth over 5 years, meaning some years could be higher, and others lower.

CAGR does not take into account investment risk, such as an unprecedented downturn, like the COVID-19 pandemic currently gripping the market. It also relies on timing too, as it is not an exact science.

If you were to invest $100 in Company X, which shows a CAGR of 10%, this doesn't guarantee that you will have $110 one year later. CAGR is calculated as an average over a series of time, often five years. Therefore, any investment made based on a company's CAGR must be made under the assumption that the investment's growth will be over a multi-year period. This means that after a five year period, with a CAGR of 10%, your $100 investment should be worth around $160.

Short-term changes don't matter!

Here at MyWallSt we have 6 Golden Rules, and one of the most important ones is 'Think Long-Term':

We've modeled our investing philosophy on the proven long-term, buy-and-hold approach that is favored by history's greatest investors. We will guide you towards developing the mindset and discipline required to make the right investing decisions every step of the way so that you can become a successful long-term investor.

CAGR should be used as a useful tool to gain some idea as to how much you can expect your investment to yield, and may influence your goals with a stock. However, it should not be an absolute expectation over the short-term. The simplest way to earn money through investing is with a long-term buy and hold strategy, as well as a little help.

If you want to learn more about the smartest way to accumulate wealth through investing, then why not try free access here with MyWallSt and browse our award-winning shortlist of stocks.

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