By: La Papillion

Today I learnt much about CAGR.

No, it’s not a new brand of cigar. CAGR stands for compound annual growth rate. It’s a nifty mathematical formula to calculate the rate at which an investment grows linearly in a given period.
It all springs from the basic future value/present value equation:

Future value = Present value x (1 + i)^(t)

where i – interest rate compounded per per year
where t – time in years

Appropriate adjustment can be made if the compounding period is less than a year. Just change the appropriate figure for the time.

I saw CAGR all the time in brokerage report, yet I do not understand what it is until I was forced to come to terms with it while analysing some presentation materials for china milk. It helps that prior to that, I was reading intensively on a lot of books that give calculates the growth rate for their investment using this method (though they might not call it by the same name).

A good example should be able to illustrate the finer points of the formula:

Let’s say that in 1st Jan 2005, I started my investment portfolio with $10,000
In 1st Jan 2006, I made a loss, so my portfolio drops to $8000
In 1st Jan 2007, I recouped my loss somewhat and my portfolio stands at $9500
In 1st Jan 2008, my portfolio ends at $12,000

To calculate my CAGR, I just plug it into the formula:

Present value = 10,000
Future value = 12,000
time period = 3 years

i or CAGR = 6.27% compounded annually

When CAGR is used, one must be careful of the assumptions behind the formula:
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