Compounded Annual Growth Rate(CAGR) is a widely used return metric because it truly captures the year-on-year return earned by an investment, unlike absolute return that captures the point-to-point return from an investment without considering the time taken to earn it.
CAGR is preferred because it allows returns to be compared across different asset classes by providing the average annual return earned by an investment based on the initial invested amount, the final value of investment and the time-period lapsed. If an investment of Rs1000 made 5 years ago is worth Rs.1800 today, while the absolute growth rate is 80%, its CAGR is the average return the investment earned every year. The CAGR works out to be 12.5%. If you had to compare this with a bank FD that promised 12.5% per annum, CAGR makes it easier to compare.
Similarly, if you had to calculate the return earned by your investment after removing inflation, which is an annual figure of say 4%, CAGR makes it simpler to calculate that you really earned 8.5% after removing inflation. CAGR is useful when returns are compared for period greater than one year. The investment may have given more than 12.5% in some years and less than 12.5% in other years but on an average, it grew by 12.5% annually during the 5-year period.
