When dealing with investments (including stocks), CAGR is how you can describe the average growth of something over a period of time. The acronym stands for Compound Annual Growth Rate.
For instance:
- Let's say that I buy $10,000 worth of stock.
- After one year, it's worth $9,000 (a 10% decrease)
- After two years, it's worth $12,000 (a 33% increase)
If I wanted to brag to my friends, I'd say "I made 33% on my stock from last year!" Anyone who has known me a bit longer would probably be more interested in what kind of return (percentage-wise) I had made in total since I initially purchased the stock (CAGR).
This is calculated as follows:
CAGR = A ^ B - 1
where
Ending value
A = --------------
Beginning value
and
1
B = --------------
# of years
so for our example,
A = 12,000 / 10,000 = 1.2
B = 1 / 2 = 0.5
CAGR = 1.2 ^ 0.5 - 1 = 0.0955 (approximately) or 9.55%
You can double-check this by using that value each year and working forward
- Initial stock purchase of $10,000
- Increase of 9.55% ($955) = $10,955
- Increase of 9.55% ($1046) = $12,001
On a side note, it is interesting that the "simple" calculation most people would make for the above example goes like this:
- I have $12,000 now.
- I started with $10,000.
- That is $2,000 profit, which is 20% of $10,000 over 2 years.
- I made 10% profit each year.
Sticking with the CAGR formula prevents such mistakes from happening.
