Crack the code of investment returns! Whether you are tracking a stock’s surge or evaluating a mutual fund’s consistency, knowing how to measure performance is the ultimate superpower for any investor. Discover how to analyze and calculate various types of returns, making your investment journey easy.
While looking at sales, profit numbers, or returns, have you ever wondered at what rate the numbers have grown? It is easy to get dazzled by big percentages, but without context, those numbers can be misleading.
Today, let’s unlock the secrets of calculating growth rates using some handy formulas. With these tools, you will gain valuable insights into the performance growth and returns offered by your favorite companies and be able to make informed decisions about your investments—whether it’s equities, mutual funds, ETFs, FDs, bonds, or more.
So, let’s begin.
Absolute Returns
Let’s illustrate the concept of absolute returns with an example. Imagine a person telling you that he has read 100 books. At first, you would think that the achievement is quite impressive. But then you understand that the person has read 100 books in 10 years. That’s ten books a year! The accomplishment suddenly just lost its shine.
This is what happens in absolute returns. It does not take into account the time taken to earn the return.
Let us now take the example of the sales growth of two companies.
- Company A went from a mere sales of Rs 10,000 to Rs 50,000
- Company B went from sales of Rs 10,000 to Rs 40,000
You would undoubtedly invest in company A, and that’s what absolute returns would also tell you to do.
Absolute Returns = (End Value – Initial Value)/Initial Value
Sales growth of Company A = (50,000-10,000)/10,000 = 400%
Sales growth of Company B = (40,000-10,000)/10,000 = 300%
According to absolute return, your decision to invest in ‘Company A’ seems correct. But, here comes the limitation. Absolute returns do not consider time in the equation.
Compounded Annual Growth Rate (CAGR)
CAGR takes ‘time’ into the picture and tells us how much returns an investment option offers over a certain period.
If we refer to the above example, CAGR will tell us how much sales growth the company has achieved annually.
If we tell you that Company A achieved 400% sales growth in 10 years while Company B only took 5 years to achieve 300% sales growth. Still, will you invest in company A as per the absolute return formula? We bet not because it does not sound correct.
Let’s look at the CAGR in sales of companies A and B.
CAGR = (End Value/Initial Value) ^(1/time) -1
CAGR Company A = (50,000/10,000) ^ (1/10)-1 = 17.46%
CAGR Company B = (40,000/10,000) ^ (1/5)–1 = 31.95%
As you can see, Company B has made a higher sales growth yearly than Company A.
CAGR vs Absolute Returns in Stock Price
Let’s say you had invested in a stock X in 2015 for Rs 500. In 2023 you sold the stock for Rs 1,000. How much returns have you earned?
Absolute returns = 100%
CAGR = 9.05% (500 invested for eight years)
If you are wondering which method is the best? CAGR or Absolute. The truth is both methods do not take into account the volatility of the investment. In the above example, we had invested in Stock X at Rs 500 in 2015 and sold it at Rs 1,000 in 2023; the stock price might have fluctuated a lot during these eight years. But, in both formulas, we consider the initial and final investment values, not the volatility.
Despite this, CAGR is commonly used as it provides a clear understanding of annual returns over a certain period.
Extended Internal Rate of Return (XIRR)
We now understand that CAGR will help us understand annualised returns over a certain period. But, in the case of CAGR, we invest the entire capital at once. But what if you have made an SIP in a mutual fund where you would invest a certain monthly sum for the next few years? In this case, we consider XIRR returns.
Let’s say you invested Rs 3,000 in a mutual fund through an SIP with a starting date of 1st January 2022 and an end date of 1st December 2022. Over these 12 months, you invested a total of Rs 36,000, and the current value of your mutual fund investment is now Rs 45,000.
Calculating the CAGR for this investment won’t give us an inaccurate picture since the first SIP installment had 12 months to grow, while the tenth SIP instalment had only two months to grow. Hence we calculate XIRR, which can be quickly done through an excel sheet or online calculator.
In this case, our investment of Rs 3,000 monthly resulted in a whopping XIRR return of 49%.
To conclude, understanding various return formulas is crucial in finance. Knowing which formula to use can make a difference in making wise investments.
To analyse sales and profit growth or lumpsum investments, use CAGR, while XIRR is for SIPs.
Using the correct formula gives you a clear picture of past returns, which will help you make well-informed decisions. While investing, understanding which type of return is being discussed is essential. This knowledge will help you choose better investment options and deploy your investment in the right place to create wealth.
Final Verdict: Choosing the Right Tool
To conclude, understanding various return formulas is the difference between guessing and truly knowing your wealth’s progress. While all these formulas help you look back, they serve very different purposes:
- Absolute Returns: Use this for short-term trades (less than a year) where time isn’t a major factor.
- CAGR: Use this to analyze sales and profit growth or to compare lump-sum investments across different time frames.
- XIRR: Use this exclusively for SIPs, multiple buy-ins, or irregular cash flows to get the most honest picture of your performance.
Using the correct formula gives you a clear picture of past returns, which will help you make well-informed decisions. While investing, understanding which type of return is being discussed is essential. This knowledge will help you choose better investment options and deploy your capital in the right place to consistently create wealth.
Note: This article was originally written by Teji Mandi for ET Markets.
Read the article here. https://economictimes.indiatimes.com/markets/stocks/news/learn-with-etmarkets-understanding-cagr-xirr-and-absolute-return/articleshow/98559568.cms
