How CAGR analysis can help you time your entry and exit in equity investments?

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Compounded annual growth rate (CAGR) analysis is a useful tool for equity investors. CAGR helps you determine the annual growth rate of an investment over a period of time. Understanding CAGR can help you make better decisions about when to enter and exit investments. This article explains what CAGR is, how to calculate it, and how you can use CAGR analysis to improve your equity investment timing.

What is CAGR?

CAGR stands for “compounded annual growth rate.” It measures the annual growth rate of an investment over multiple years. CAGR shows the constant rate at which an investment would have grown if it grew at the same rate every year. This smooths out fluctuations in growth over time.

For example, an investment that grew 50% in year 1 and 10% in year 2 did not grow at an average rate of 30%. It grew at a CAGR of 28.4%. The compounding effect of earlier growth results in a higher overall growth rate.

How to calculate CAGR

Calculating CAGR requires three key inputs

Initial value – The starting value of your investment
Final value – The ending value of your investment
Number of years – The time period between starting and ending values

Once you have these inputs, use this formula to calculate CAGR

CAGR = (Final Value / Initial Value)^(1/Number of Years) – 1

Let’s walk through an example. Say you invested Rs.10,000 in a stock. After 5 years, your investment is worth Rs.18,000.

Your inputs would be,

Initial value: Rs.10,000
Final value: Rs.18,000
Number of years: 5

Plugging this into the formula

CAGR = (Rs.18,000 / Rs.10,000)^(1/5) – 1

CAGR = 1.12 – 1

CAGR = 12%

So your annual compound growth rate was 12% over the 5 year period. The investment’s value grew by 12% each year.

Using CAGR to evaluate past performance

One of the key uses of CAGR is evaluating an investment’s historical performance. CAGR provides a straightforward metric you can use to compare returns across different assets classes and time periods. For example, you could use CAGR to compare the 5-year return of stocks to bonds. Or the 10-year return of real estate to gold. The CAGR metric normalizes growth rates over different periods into an annualized percentage.

When looking at a stock investment, calculate the CAGR over the entire holding period. For a mutual fund, use since inception CAGR. For an index, like the Nifty 50, evaluate CAGR over rolling multi-year periods like 5, 10, or 20 years. Comparing CAGR figures helps you see which investments have delivered the highest compound growth historically. This may influence future investment decisions.

Using CAGR to project future returns

In addition to evaluating past performance, CAGR can help project possible future returns. If you assume similar growth patterns will continue, the historical CAGR gives an expected rate of return. For example, if a stock has averaged 15% CAGR over the past 10 years, it could potentially continue growing at a similar rate. That 15% figure serves as an estimate of future expected return.

To forecast future value using CAGR, you would use this formul:

Final Value = Initial Value x (1 + CAGR)^Number of Years

So, if you invest Rs.10,000 today in a stock with estimated 15% CAGR, in 10 years it could be worth:

Final Value = Rs.10,000 x (1 + 0.15)^10
Final Value = Rs.10,000 x 2.61
Final Value = Rs.26,100

The initial investment compounds to over Rs.26,000 in 10 years assuming 15% annual growth continues.

Using CAGR to time your entry in investments

CAGR analysis helps inform better entry timing into investments. History shows that equity returns tend to regress to the mean over long periods.

Following years of below-average returns, investing when CAGR falls near historical lows can provide attractive entry points. You buy in at lower valuations before growth accelerates again. For example, consider the Nifty 50 has returned about 12% annualized over the last 25 years. If the 10-year CAGR for the index currently sits at 8%, it may be a good time to invest in a low-cost index fund tracking the Nifty 50. Odds favor a regression to 12%+ returns over the subsequent decade based on history.

You can apply similar CAGR analysis to an individual stock investment. Is the current 5-year CAGR unusually low compared to the past 10 or 20 years? If so, it indicates a potential opportunity to invest before growth improves.

Using CAGR to time your exit in investments

CAGR analysis also helps with timely exits. Following years of above-average growth, current CAGR highs suggest potential peaking performance. Trimming or exiting positions when invested in overextended, overvalued assets avoids buying right before a regression to the mean. As unsustainable growth rates revert back toward historical norms, you protect recent gains by selling.

For example, the 5-year CAGR for a stock investment approaches 30% compared to a 15% 10-year CAGR. The stock likely overextended and could see slowing growth ahead. Reducing your position size when CAGR reaches elevated extremes can help lock in gains.

However, you still need to consider the fundamentals. An above-average CAGR period driven by genuine growth may sustain itself. Do not rely on CAGR alone when deciding when to take profits. Use it as one input along with a holistic analysis of the investment outlook.

Conclusion

CAGR provides a straightforward way to measure annual compound growth rates over time. Analyzing historical CAGR can inform future return projections and help time entry and exit points. Comparing CAGR across investments and benchmarks aids decision making. Combine CAGR analysis with a review of fundamentals and valuations as part of an overall research process to improve investment timing. Monitor CAGR regularly to detect changes in performance trends. With the right context, CAGR can be a valuable tool in your equity investing toolkit.