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The compound annual growth rate is a financial calculation that makes it possible to determine the average year over year growth rate of an investment. The compound growth rate is often used to ensure that the return on a given investment is following a favorable trend. At the same time, the CAGR can be a means of identifying a downward trend that could make it wise for the investor to sell off the investment before the current value drops below the initial base value or purchase price.
Figuring a compound growth rate is based on determining the number of years that will be used in the calculation. For example, if an investor wishes to calculate the growth rate for a five year period, the base value for the most distant year serves as what is known as the starting value. The base value for the most recent year under consideration serves as the ending value. In order to begin the process of calculating the compound growth rate, the ending value is divided by the starting value. This result percentage is then factored by the nth root, where n is understood to be the number of years involved in the calculation. The final figure will be the average or compound annual growth rate for all the years involved in the period.
Generally, a compound annual growth rate is calculated to apply to five-year periods. This is considered to be an adequate sampling that allows for the usual ups and downs within any given market. However, it should be understood that the compound annual growth rate is an average, and not an actual rate of growth for each year under consideration. There could be a substantial difference between the exact rate of growth or decline from one year to the next and the calculated compound annual growth rate.
Still, the compound annual growth rate is a quick and easy way to get a feel for the overall growth pattern of a given investment. Because the compound annual growth rate is a geometric average rather than an arithmetic average, it has the advantage of allowing for rises and drops during the period cited. Thus, it is possible for the investor to see the cumulative result of any real growth within the investment over time.