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Compound Annual Growth Rate or CAGR in Equity Stocks
Okay. Todays topic about *CAGR* or *Compound Annual Growth Rate*
CAGR method is a method of finding out how much compounding results we are getting on our investment.
Important of portfolio measurement
Yesterday, we discussed about Portfolio measurement and used the *Benchmark with the Index* method.
In that method, we compared our portfolio with that of the chosen benchmark (such as CNX 100).
We used that method to identify the lagging stock or lagging sector amongst our 5 stocks.
By doing such identification, we can replace the not-so-well performing stock / sector with something else.
So, it is not just a portfolio return measurement too but also an elimination / optimization tool.
Because it shows the a potential candidate for replacement.
To replace the lagging stock, we need to book profit and exit from it.
We also said that this method is to be used for short term or medium term stock.
Need for CAGR
For long term investments, i.e for investments made over a year, the *CAGR method* is a better one.
Before entering into the concept, let us understand the need for a method such as CAGR.
Consider this example:
Assume that you invested in a stock for near to 5 years.
Assume that the investment gave us the following hypothetical returns:
Year 1 : 26% Year 2 : -22% Year 3 : 45% Year 4 : -18% Year 5 : 44%
For the above data, the Average annual return is 15.00%
Now, is this the best way to report the investment returns?
Make a guess.
May be not.
Actually it not even a fair method.
Because it doesn't consider the concept of compounding
The above method is right if each investment is taken as a fresh transaction.
This is why, we brought the concept of ..
- CAGR* or *Compounded Annual Growth Rate*
You may have noticed the term 'Compound' was included.
Let us take the CAGR calculation step by step.
It is a bit complex to explain over chat.
But if u put some mind, u will understand the calculation.
I will explain with a numerical example later.
First understand the steps
Divide the value of an investment at the end of the period in question by its value at the beginning of that period
Raise the result to the power of one divided by the period length i.e (1 / number of years), and subtract one from the subsequent result
The formula looks like this:
Ending Value ( 1 / Number of years) CAGR = (---------------) - 1 Beginning Value
We will take a numerical example
Assume we have an investment of Rs. 10,000 in a stock as of January 1, 2013.
The stock appreciated and its value became Rs. 17,500 by January 1, 2016.
We are excluding any expenses such as charges, taxes, loads etc.
So assume Rs. 17500 is what u finally got to ur bank account after the sale.
We just substituted the values into the formula
Beginning Value = 10000
Ending Value = 17500
- of years = 3
CAGR will be:
[(17,500 / 10,000)^(1 / 3)] – 1
= (1.75 ^ 0.3333) – 1
= 1.2050 – 1
= 0.2050, or 20.5%.
So, the stock had a CAGR of 20.5% (which is a good number)
i.e A compounded growith of 20.5%
Understood how CAGR is calculated?
You can easily implement this in Excel if you know a bit of how to use formulas.
Remember, in our excel sheet, we have Date field, we have investment amount, we have units, we have current NAV and we know todays date.
Like i said, first get Todays date - Investment date. this will gives number of days of investment
If Days < 365, use simple interest forumal used earlier.
If Days > 365, use CAGR formula
You can use =IF() condition checking to determine that.
If I individually calculate CAGR for each SIP transaction then how do I get the overall CAGR for my investment into any scheme? Do I do average of all CAGRs?
For that u need to use the Internal Rate of Return formula
=IRR () function
And if you mix SIP with some intermediate lumpsum methods, it will be even more difficult to calculate
For that we need to use XIRR()
Please visit this website that gives information on excel implementation of the IRR and XIRR calculations. http://www.jagoinvestor.com/2009/08/what-is-irr-and-xirr-and-how-to.html
CAGR is a simple calculation.
It is a simple method of computing compounded gains.
CAGR is used because when markets are volatile, the year-to-year growth of an investment may be difficult to interpret.
We already know, commodity stocks have a cycle.
There will be an initial stage, then stock moves up and then after a year, stock comes down and then again goes up etc.
Basically cyclical, seasonal characteristics
The best example for this is our sugar stocks.
Sugar stocks and most agri commodity stocks are totally out of flavor till this year.
And now almost all of them are rallying.
The rally is occurring after almost 8 years.
So if you invested in sugar stocks and got stuck 8 years ago, you will see that your investments are now giving returns
So you might be interested in computing CAGR in them
Another advantage of CAGR is that it can be used to compare with different asset classes.
For example, you can compare investment in XYZ share with that of say, Gold.
- Assignment Alert*
Compute CAGR of Nifty 50 for the period 1 January 2011 to 1 January 2016.
We learned that wealth is created by investing in good quality stocks for many years. How do we know that it’s time to exit from a particular stock, as the returns from the stock is expected to be limited in the coming years compared to some other good stocks in the same sector? Do we need to evaluate our compounded annual return (CAGR) from the particular stock every year? Or any other criteria?
Yes. Returns for holdings over 1 year are best computed using CAGR. If you made ad-hoc investments in between, XIRR or other such methods can be used.
When to exit a stock depends on our analysis on three factors:
1. Management quality
If you feel any of the above factor is deteriorating, you should consider switching to a better company.
- Introduction to these Lessons; Savings vs Investing
- Equity Investing Rules Book
- Basic Terms on Investing
- Market Timings: Pre-market, Post-market, After Market Order
- Cost Averaging, Systematic Investing or SIP
- Value Averaging (VA)
- Modified Value Averaging (MVA)
- Fundamental Analysis and Technical Analysis
- Setting up Investing Rules: Rule 1 and 2
- Introduction to Financial Ratios used in Stock Analysis
- Using SuperTrend and Parabolic SAR for trading and investing