Key Concept in Calculating Returns on the Investments -> CAGR

What Does Compound Annual Growth Rate – CAGR Mean?

The Compounded Annual Growth Rate (CAGR) is the rate at which something (e.g., Revenues, Savings, Population) grows over a period of years, taking into account the effect of Annual Compounding.

A Compound is composed of two or more parts. In the case of compound growth, the two parts are Principal and the Amount of change in the principal over a certain time period, which is called “interest” in some circumstances.

This is sometimes called “growth on growth” because it measures periodic growth of a value, that is itself growing periodically. If we are calculating the annual compound growth rate, then each year the new basis, is the previous basis plus the growth over the previous period.

Thus, a Compound Annual Growth Rate (CAGR) measures the rate of return for an investment — such as a Mutual Fund or Bond — over an Investment period or Horizon, such as 5 or 10 years.

The CAGR is also called a “Smoothed” rate of return, because it measures the growth of an investment, as if , it had grown at a steady rate on an annually compounded basis.

It’s Significance & Importance :

In looking at an Investment, the CAGR is a measure that is commonly used to show how quickly the investment, or certain aspects of it, such as gross sales, have been growing.

Investment analysts often look at 5 year periods to discern a trend. A specific company’s rate of growth is often then compared with that of competitors or with the industry as a whole.

For example, Company A had a revenue CAGR of 8.5% over the past 5 years. One of its direct competitors has grown by 9.4% and two others have seen slower growth. The industry as a whole has seen revenues grow by 7.3% per year, compounded annually.

On this basis, one would conclude that Company A is doing well and in fact might be gaining market share. Of course, other factors need to be looked at, such as debt and the outlook for the industry.

                                            Formula for Calculating CAGR :

The formula for Compound Annual Growth Rate is:

((Ending Value/Beginning Value)^(1/# of Years))-1

There are five variables in a compound growth rate calculation:

Beginning value
Ending value
Length of time between the values
Periodic scale (days?, months? years?)
Periodic rate of change

You need to know four of these values to make the calculation of the fifth.

For example, Company A had revenues of $1.35 billion in 2002. Revenues grew by a CAGR of 8.5% through 2007, a period of five years. We know the beginning value, the length of time, the periodic scale (years) and the periodic rate of change. Now we can determine what the revenue was in 2007.

CAGR (Compounded Annual Growth Rate) is growth rate annualized over a period of time. This is not actual growth year on year, but it shows the annualized growth, if the same Investment would have experienced a steady growth rate over the period. Let’s understand it with an example:

Year ->                                                                       0              1            2            3                 4               5                    6

Growth Rate (%)  ->                                                          20         -8           11               -5             35                   5

Value of Investment (Principal) ->    100       120    110.4      122.54     116.42    157.16       165.02

CAGR will be calculated based on the evidence that an Investment of Rs 100 turned out to be Rs 165.02 in 6 Years.
CAGR will be (165.02/100)^(1/6)-1 = 0.0871=8.71%

1 More Example :

Say the sales of a Company 4 years back was 100. Today, after 4 years, it is 200. A simple conclusion is that sales has increases by 100% in 4 years. But does it mean that it has increased by 25% each year?

That would not be correct, as simply dividing 100% by 4 doesn’t take into consideration the compounding effect.

So, to find out the per year growth rate of a company, we use the compound interest formula.

A = P * ( ( 1 + r ) ^ n )   Same as above formula, but in a Simplified Notation for better Understanding

Where
A = Final Amount
P = Principal amount
r = Rate of interest, expressed in %
n = Number of years

In our example,

A = 200
P = 100
r = The annual growth rate (that we want to find out)
n = 4 years

From this formula, we find out that r is around 19%.

How do we interpret this?

It means that the average growth of the company over these 4 years, taking into account the impact of compounding, is 19%.

In the first year, the company grew from 100 to 119. In the second year, it grew 119 to 142. In the third year, it grew by 19% from 142 to 168.5, and in the fourth year, it grew from 168.5 to 200.

This principle is very important to understand, because it is used at many places.

For example, it is looked at while examining at returns generated by mutual funds (MFs). Whenever one sees returns for more than 1 year, they are expressed in terms of CAGR. If they are not expressed in CAGR terms, the returns are not accurate!

Let me know your thoughts on this Article.

Types of Inflation & its Basics

There are two theories in the economics that are generally accepted as the causes of inflation.

• Demand pull inflation – Happens when too much Money chases too few Goods.

This situation mostly exists in a Growing economy (Like India), where there are huge expansions from the Government and Private Sector, leading to increase in employment, which in turn will increase the purchasing power of the consumer.

This leads to an environment, where people have got too much money to buy goods and/or services, but the supply of goods and services are not growing at the same rate, resulting in a supply and demand mismatch. To adjust this, producers will increase the price of goods.

• Cost push inflation – Happens when the aggregate cost of resources goes up, for the companies due to decrease in supply or increase in taxes. This situation primarily exists in Developed Economies such as US or UK.

Companies pass this increase on to consumers in the form of increased prices. For example, Crude oil prices have gone up sharply in past few months on account of decrease in supply. The economy sectors where oil is the part of their cost element, will pass on this increase to customers by increasing prices of their goods and services.

It is not necessary that only one type of inflation exists in an economy at a time. They can co-exist.

For instance, in India right now we have both types of Inflation, Oil and Metal prices have gone up to record highs, giving rise to Cost Push Inflation. At the same time, purchasing power has also increased due to increases in employment, wages, and easy availability of money, creating Demand Pull Inflation. This combined effect has taking inflation to the 13-year high that we are experiencing right now.

Inflation is not always an Evil.

Within limits, Inflation is required for an Economy to grow. It’s very well said that inflation is the sign of a growing economy. Imagine an environment where there is no price increase; in fact prices are falling (this situation is opposite of inflation known as deflation). There will be no increase in wages. Nobody would like to have that environment.

But when inflation is too high it adversely affect the consumer and the economic conditions of the nation as well:

• In a fixed interest rate environment the Creditor will lose money, if he has not properly estimated the inflation and accordingly fixes the interest rate. High inflation can sometime result in negative real interest rates. This can be currently seen in India as the inflation is touching 11.4% and the interest rate on fixed deposit is 9% it is actually giving negative return of 2.4%
• It decreases the savings of the individuals. As the prices increase, the consumer has to shell out more money from his pocket to buy the same products but his income has not increased. Therefore he has to eat up his savings.
• As savings get reduced, automatically investments will reduce, affecting the economy negatively.
• If the inflation in one country is greater than another, the products and services of the former will become less competitive due to the increase in its prices.

To control inflation Central Banks, take Monetary actions and government takes fiscal measures. But individuals should also take some steps to get over it. They should invest their money in the investment avenues which gives better return, should try to minimize unwanted expenses, reduce the consumption of the commodity that has become very expensive, and find out some substitute that will help them in managing their own inflation.

Additions, Suggestions for Improvement & your feedback is always welcome.

Hope this article helps you in some way.

What is Debt and Equity?

When we talk about Asset Allocation and selecting Financial Products, we also need to understand the difference between the two broad Classification of Financial Products: Debt and Equity.

A company can raise Capital by using the two means – Equity & Debt

   In Simple (Layman) words : When a provider of capital loans money to a user of capital, it’s a Debt transaction. When he owns a portion of the user of capital, it’s an Equity transaction.

The basic difference between Debt and Equity would be the ownership level. Let’s take an example where you invest in me.

If you give out some money to me and expect that I return the money along with interest that I pre promise, that would be a Debt investment. I’m indebted to you but since I have promised you a return with interest, you don’t actually own me.

In other words, by investing in a Debt instrument such as a Bond, you are guaranteed the Principal of the bond, plus any interest that is owing.

In another case, you give me money at your own risk. But you trust me/hope that I’ll be a billionaire in the future and I’ll payback from my profits. The more profits I make, the more you do. If I am bankrupt, you don’t get anything back. And so you have invested in my Equity.

By trusting me, you own me in a way!

Equity refers to part ownership in a company, and in the Indian context – Equity and Shares (Stocks) are used interchangeably.

So, if  Bharat/knowledge2finance  were a company that had 100 shares in the market, and if you bought 1 share of knowledge2finance – you would be the owner of 1% of knowledge2finance.

If knowledge2finance was valued at 1 lakh Rupees today, then your share would be worth Rs. 1,000.

If 5 years from now – knowledge2finance were valued at Rs. 10 lacs then your share would be worth Rs. 10,000.

If however, the company went bankrupt then your share would be worth nothing. Equity products are generally considered to be high risk – high return products for this reason.

       However, for equity investors, you become an owner. As such, you also take on the risk of the company not being a success. Just as a small business owner has no guarantee of success with each new venture, neither is a shareholder. As a shareholder, if the company is successful, you stand to make a lot of money. On the flip side, you stand to lose a lot of money if the company is less than successful.

                                         Examples of equity products:

   Shares/Stocks: Shares trading on the stock exchange are the most direct examples of equity products.

Equity Mutual Funds: Mutual funds that own shares are another example of equity products. ELSS mutual funds that are eligible for 80C tax savings are a popular example of equity mutual funds.

Equity based ETFs: ETFs that are based on shares like Nifty Index Funds are also an example of equity products.

                                                       In other Words : 

      Equity means ownership. Everyone who owns an equity share of a company owns a part of the company. He/she can influence the decision-making in the company

Debt represents an obligation.

Debt is loan, and carries a fixed rate of interest, and a promise to repay. Debt is generally safer than equity, and there is generally no upside in it. You get paid the promised interest, and as long as the company (or country) is not bankrupt – you’re safe.

Examples of debt products:

Fixed Deposits with banks (FD) are the prime example of debt products. They are extremely safe investments, which have a pre-determined interest rate. The stock of SBI may have wild swings but your fixed deposit with SBI is safe, and won’t be affected till something really serious happens.

Infrastructure bonds that have recently been launched are another type of debt product as they pay you a fixed interest rate, and the principal is protected as well. They are not as safe as bank fixed deposits, but if any infrastructure company defaults on their debt – that would be an exception rather than the norm.

Fixed Maturity Plans (FMPs) – These are a special type of mutual funds that have become popular in the past few years, and work like fixed deposits (though not as safe as them). They have become popular due to favorable tax treatment when compared with a fixed deposit,  so people don’t mind taking the little bit of extra risk.

Post Office Monthly Income Scheme (POMIS): Post Office schemes are also debt schemes as they pay a fixed interest, and are also guaranteed. These are very safe instruments.

Provident Fund (PF): This is also a debt product, which is quite safe and pays a fixed rate of interest.

These are some of the key things that come to my mind when explaining the difference between a debt and an equity product – feel free to add anything that I have missed, and as always – comments are welcome.

Relation between Inflation and Bank Interest Rates: How does Inflation affect rates?

 “Inflation is the overall or specific increase in the cost of goods or services.”

Inflation is an increase in the price of a basket of goods and services that is representative of the economy as a whole.

Inflation is basically a rate of increase in the price of goods and services which in economics defined as “The overall general upward price movement of goods and services in an economy, usually as measured by the Consumer Price Index (CPI).”

In India, however, it is measured using the wholesale price index (WPI).

The CPI is based on a basket of goods and services with different weights, reflecting the expenditure of a typical consumer. The weighted average of price rises of these goods and services gives the inflation figure.

Inflation simply reduces the worth of our money. For example: the same 1 kg of apples you used to buy at Rs. 100 will cost you Rs. 110 next year, if the inflation remains at 10%.

Inflation is when our Mom or Dad complains about the prices they have to pay nowadays compared to what they paid when they were younger. “I remember when a roll of Poppins only cost 20 paise.” “I used to buy Tur dal at Rs.14/Kg.” “When did milk get so expensive?” My Great Grandfather used to get a salary of Rs. 5 per month!!

Most people look at their present living standards and estimate how much they will need to accumulate to survive. They don’t even take a second look at inflation. India’s Inflationrate is currently above 9%. There are no Fixed Deposits which give such high returns. This means that for ever year that your money is in the bank you are actually losing money!!  Inflation is Eroding the value of our money lying idle in Savings Accounts in Banks, as it is fetching us only 4% ROI.

The best way to beat inflation when planning for the future is to include it in your calculations. The biggest problem we see with a lot of long-range financial planning, especially retirement planning, is that people forget to factor in the effect of inflation on their investments and savings.

Another quick way to account for the effect of inflation is to subtract the inflation rate from any rate of interest you will be receiving on an investment. So if you are going to assume a 10% inflation rate and the assumed rate of return is 11%, do the projection with only a 1% rate of return. This will give you a more accurate picture of the value (not the amount) of the investment at its maturity!!!.

If inflation is high, interest rates are increased. If repo, ie rates at which banks borrow from RBI, is increased, such borrowing will become costly and banks would thus either borrow less or pass on this increased cost to their borrowers. Again if reverse repo is increased, banks would divert more funds towards RBI and excess liquidity will be absorbed by RBI rather than going at cheaper cost in the economy. In either of the cases, actual lending will be less and demand for goods and services will be less

In the case of CRR, if the rate is increased, it affects in two ways. First, immediate liquidity in the system is absorbed to the extent CRR is increased as more money needs to be placed with the regulator. Second, in the incremental lending, potential capacity of banks to lend is curtailed. This again leads to less lending by banks.

How is inflation calculated in India?

India uses the Wholesale Price Index (WPI) to calculate inflation. Most developed countries use the Consumer Price Index (CPI) to calculate inflation.

      What is Wholesale Price Index (WPI)?

Wholesale Price Index (WPI) is the index that is used to measure the change in the average price level of goods traded in the wholesale market. In India, a total of 435 commodities data on price level is tracked through WPI which is an indicator of movement in prices of commodities in all trade and transactions. WPI is published on a weekly basis in India.

    What is Consumer Price Index (CPI)?

CPI is a statistical time-series measure of a weighted average of prices of a specified set of goods and services purchased by consumers. It is a price index that tracks the prices of a specified basket of consumer goods and services, providing a measure of inflation. In India, CPI is published on a monthly basis.