When looking at your investment returns for a stock like Tata Motors share price, or while reviewing the different investment returns, you may find two types of statements. Some say, ‘The investment grew 53% in 5 years’, while others mention ‘it grew 13% every year for 5 years’. What exactly is the difference between the two? Here, one gives the absolute returns figure, and the other gives the CAGR return rate. How do these differ? Let’s understand.
What Are Absolute Returns?
Absolute returns measure the total return on an investment over a specific period, showing how much the investment has grown or decreased in value. Absolute returns reflect the overall profit or loss from the investment without comparing it to any benchmark. These returns can be positive or negative. The formula for calculating absolute return is
Absolute Return = [(End Value – Initial Value) / Initial Value] x 100
For example, you invest Rs.1,00,000, and your investment grows to Rs.3,00,000 after some time. So, the absolute return will be
Absolute return = [(300000 – 100000) / 100000] x 100 = 200%
That means the fund increased by 200% over the tenure of the mutual fund.
Now, say the fund grew 200% in 10 years. This is where absolute returns fall short; it won’t specify whether the growth was 10% in one year, 13% in the next, and 5% after that, or whether it consistently grew at 10% per year. Just like if someone told you they read 100 books, you’d be impressed at first. But if you found out, it took them 10 years, that’s just 10 books a year—less impressive, right?
How does it make a difference? Let’s look at two companies’ sales growth:
Company A’s sales grew from Rs.20,000 to Rs.60,000
Company B’s sales grew from Rs.20,000 to Rs.50,000
Using absolute return, you’d calculate:
Company A sales growth = [(60000 – 20000) / 20000] x 100 = 200%
Company B sales growth = [(50000 – 20000) / 20000] x 100 = 150%
Based on absolute returns alone, you’d likely invest in Company A. But here’s the catch— absolute returns ignore the time it took to reach those numbers. This is where the Compound Annual Growth Rate (CAGR) comes into the picture.
What Is CAGR?
Compounded Annual Growth Rate (CAGR) measures how much an investment grows over time, assuming all profits are reinvested. It shows the annual growth rate of an investment, helping you understand how it reaches its final value. CAGR makes it easier to compare the performance of different investments over a set period. CAGR can be calculated using a CAGR calculator or the following formula-
CAGR = [{(Ending value / Beginning value) ^ (1/n)} – 1] x 100
where,
- The ending value is the investment’s value at the end of the period.
- The beginning value is the investment’s value at the start.
- n represents the number of years the investment is held.
Let’s see if the earlier decision of the two companies remains the same or changes basis the CAGR returns. Say Company A’s sales grew from Rs. 20,000 to Rs. 60,000 in 10 years, and Company B’s sales grew from Rs. 20,000 to Rs. 50,000 in 5 years. As per the CAGR formula, sales growth for the companies will be-
- Company A CAGR = [{(60,000 / 20,000) ^ (1/10)} – 1] x 100 = 11.61%
- Company B CAGR = [{(50,000 / 20,000) ^ (1/5)} – 1] x 100 = 20.11%
Company B has experienced higher annual sales growth than Company A. Thus, the decision has now shifted to Company B as a preference for investment based on other factors as well.
CAGR helps you compare different investments and plan your financial future. For example, if stocks have a CAGR of 18% and bonds have 15%, you’ll likely choose stocks because of the higher return. It also helps estimate the average growth of an investment. Even if your investment grows 10% one year and only 2% the next, CAGR smoothens out the ups and downs, giving you a clearer picture of its overall growth.
Bottomline:
Both absolute returns and CAGR returns help you understand investment returns, but they measure different things. Absolute returns only consider the initial and final values of the investment. On the other hand, CAGR looks at the annual growth rate over time, making it more useful for long-term investments.
CAGR offers a clearer picture of growth for longer periods, as it helps compare multiple investments with different timeframes. However, for investments shorter than a year, CAGR may not accurately reflect actual returns. So, when selecting your measure of comparison, consider the investment’s duration and analyze accordingly.
FAQs:
- What is XIRR?
Extended Internal Rate of Return is a method used to calculate the returns on mutual fund investments when the investment periods are irregular.
- Is CAGR better or the absolute returns method?
Both measures are useful for comparison; however, the right one depends on the investment tenure. CAGR is ideal for long-term investments as it calculates annual growth over time, while absolute returns measure the difference between the initial and final values, ignoring time. For investments under a year, absolute returns are simpler.
- Is CAGR an annualized return?
Yes, CAGR is the same as annualized return. Both terms measure an investment’s performance over a specific period, showing the growth from the starting value to the ending value over that time.
