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Can someone explain to me how the Compound Annual Growth Rate – CAGR works? I came across this and I think I understand it, but I'm not sure. If someone could give me a simple explanation on how it works so I can confirm how it's used, that would be helpful.
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Is this a homework question?
Brian -
CAGR gives you what the rate of return is over a period of time. An example is that you have a stock that was $10 in 2000 and is worth $1000 in 2010. To find CAGR over the 10 year period you would do the formula [(ending value/initial value)^(1/number of periods)]-1..
[(1000/10)^(1/10)]-1 which would be 58.49%Comment
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So is this the compounded interest rate of return?Comment
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CAGR is a geometric measure rather than an arithmetic measure. It looks at how an invested dollar actually grows.
Consider this often used example:
In year 1, a particular investment goes up 100%.
In year 2, the same investment goes down 50%.
The average rate of return is (100 - 50)/2 = 25%.
A dollar invested on the first day of Year 1 would be worth $1 on the last day of Year 2. So then, is the 25% average rate of return a good description of what happened to that dollar? No, it isn't.
CAGR is the better measure. In this case, CAGR is 0%.Comment
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