We all have those neighborhood LIC uncles who pop up every now and then. You may be running some errands, or just taking a simple stroll and THERE HE IS! He would come up some schemes like, pay X amount and after 25 years, I would give 4x your principal. And you instantly get super excited. Your eyes become one of those slot machines, showing $$ sign and you instantly eye those 400% returns. That’s huge right? Well, apologies for breaking it to you, it is NOT. For evaluating all lumpsum investments spread over such a long period, you need CAGR or Compounded Annual Growth Rate. So let’s quickly get started with what and why of CAGR?
Why CAGR and not Absolute Returns?
So what you just calculated in above example, was absolute return. However, this is not a correct way of calculating return if it is spread over such a long period. If you are calculating it for a single year, absolute return would work absolutely fine.
Compounded Annual Growth Rate works with an underlying assumption that all your returns made over the period of one year are reinvested along with your principal. So if I have invested a sum of ₹ 100 for 5 years at a rate of 10%. After first year, my principal becomes ₹ 110. The next 10% will be counted on Rs. 110 now. Similarly, next year’s principal would be 110+10% i.e. ₹121.
Doesn’t it sound similar? Yes, back to 5th Std. Mathematics. It is indeed a derivative of compound interest. And your absolute returns would be similar to Simple Interest.
So next time you invest something for a period of time (>1 year), it is fair to assume that your money is making money each year and that is being reinvested each time. So calculate CAGR and NOT absolute returns.
How is CAGR calculated?
Formula for CAGR is as follows:
Where Vfinal is final promised amount and Vbegin is initial principal.
t is your time period in years.
So let us assume you went ahead with LIC uncle’s 4x return scheme and invested 2L in the same. Using the above formula, CAGR comes out to be 5.7%.
Now if you are evaluating an equity mutual fund at the same time for same period, you’ll realize that uncle has duped you. You could’ve potentially earned much more using other instruments.
CAGR for Business Analysis:
CAGR can also be pretty handy while you are comparing two company’s performances over a period.
One may present you with following data:
|Year||Company A Growth||Company B Growth|
Go ahead, and calculate which one is growing at a better pace. This is easier said than done. Consider evaluating the data for past 20 years. Even a bigger problem right? So, what would be a simpler solution?
Just if someone could tell me average return per year for both companies. That way, I won’t have to care about each of these figures and would simply compare those two values. That value is CAGR.
Now instead of comparing the performance using 12 values, all you need to have is two representative values called CAGR.
It’s pretty straight forward now, be a smart chap and use CAGR to gauge the return. Don’t get trapped into these gimmicks of 3x, 4x returns. Hope this adds value to your life (literally).
Until Next Time..