metrics explained

Growth rate vs Compound annual growth rate: What's the Difference?

When it comes to measuring the performance of investments, both growth rate and compound annual growth rate (CAGR) are commonly used metrics. But what's the difference between the two?

Growth rate

Growth rate is simply the percentage change in an investment's value over a specific period of time. To calculate growth rate, you simply take the ending value of an investment and subtract the starting value, then divide by the starting value and multiply by 100 to get a percentage. For example, let's say you have an investment that's worth $10,000 at the end of one year and $11,000 at the end of two years. The growth rate would be:

(11,000 - 10,000) / 10,000 = 0.1

0.1 x 100 = 10%

So, the growth rate of this investment is 10%.

Compound annual growth rate

Compound annual growth rate (CAGR) is a more sophisticated metric that takes into account the effects of compounding. To calculate CAGR, you take the nth root of the investment's ending value, then subtract 1 and multiply by 100 to get a percentage. n is the number of years over which you're measuring growth. For example, let's say you have an investment that's worth $10,000 at the end of one year and $11,000 at the end of two years. The CAGR would be:

11

1/2

- 1 = 0.104

0.104 x 100 = 10.4%

So, the CAGR of this investment is 10.4%.

Why CAGR is a better metric

CAGR is generally a better metric to use when comparing investments because it takes into account the effects of compounding. With growth rate, you're simply looking at the percentage change in an investment's value over a specific period of time. With CAGR, you're looking at the investment's average annual growth rate over a specific period of time. This is a more accurate way to compare investments because it smooths out the effects of short-term fluctuations. For example, let's say you're comparing two investments, both of which are worth $10,000 at the end of one year. Investment A is worth $11,000 at the end of two years, while investment B is worth $9,000. The growth rate of investment A would be:

(11,000 - 10,000) / 10,000 = 0.1

0.1 x 100 = 10%

The growth rate of investment B would be:

(9,000 - 10,000) / 10,000 = -0.1

-0.1 x 100 = -10%

So, investment A has a growth rate of 10%, while investment B has a growth rate of -10%. But if you look at the CAGR of these investments, you'll see a different story:

11

1/2

- 1 = 0.104

0.104 x 100 = 10.4%

9

1/2

- 1 = 0.095

0.095 x 100 = 9.5%

So, even though investment A had a higher growth rate over the two-year period, investment B actually had a higher CAGR. This is because investment B started off with a lower value, so the effects of compounding were greater. This is why CAGR is generally a better metric to use when comparing investments.

How to use CAGR

Now that you know the difference between growth rate and CAGR, you might be wondering how to use CAGR in practice. Here are a few tips:

  • When comparing investments, use CAGR instead of growth rate.
  • When calculating CAGR, be sure to use the correct n value. This is the number of years over which you're measuring growth.
  • CAGR is a useful metric, but it's not the only metric you should use. Be sure to look at other factors, such as risk, when making investment decisions.

The bottom line

Growth rate and CAGR are both commonly used metrics for measuring the performance of investments. However, CAGR is generally a better metric to use because it takes into account the effects of compounding. When comparing investments, be sure to use CAGR instead of growth rate.

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