Terms Beginning With 'c'

Compound Annual Growth Rate (CAGR)

What is Compound Annual Growth Rate or CAGR?

Compound Annual Growth Rate is the rate of return that is needed for an investment to grow over a period when the income generated through the amount invested gets re-invested at the end of each year.

Before diving deeper into the CAGR concept, let us understand what compounding means.

What is compounding?

In simple terms, compounding refers to the addition of interest on interest earned (or charged). It refers to the increasing value of an asset because of the addition of interest on principle as well as the accumulated interest. One can easily relate this concept with a mathematical concept known as compound interest.

Compound interest is computed by subtracting the principal amount from the total amount of principal and interest which we get in future. Mathematically, it is represented as below:

How can one relate CI concept with CAGR formula?

Where,

  • FV: Final value
  • PV: Present value
  • r: rate or CAGR
  • n: time

In simple terms, we can say that CAGR is the modified version of compound interest.

Where can you apply CAGR?

As an investor, suppose you look at the P&L statement of a Company and want to know the percentage growth on the equity. Let us assume that in year 1, the Company was able to generate a return on equity (ROE) of 10%, 12% ROE in year 2, and in year 3, an ROE of 15%. As an investor, we would want to look for a representative value at which the ROE increased each year. This value is the CAGR value.

Another application of CAGR could be seen when you check the revenue growth of a Company.

CAGR can be used for personal finance as well. Many investors are interested in mutual funds and want to look at a metric that indicates their respective performances. Let us understand with an example:

Calculation of YoY growth on the amount invested using Excel:

Calculation of CAGR (r):

How was the calculation done on excel?

The calculation in excel was done using the formula highlighted above.

Explanation of the above example:

Suppose you have invested $1,000 in mutual fund M, which provide you $1,200 after one year. At the start of year 2, you re-invested the amount, but you get $800. This means you made a loss which is also reflected via the image above. Similarly, in year 3, 4 and 5 you get YoY return of 69%, -4% and 15% respectively.

Overall, if you want to understand how much you return you received after investing in this mutual fund ‘M’, then using the formula you got 8.45% return.

The value which you derived would help you to understand whether it was an excellent decision to invest in this mutual fund or not. You can compare the return of other stock, mutual fund or any financial product and accordingly take a decision.

The Rule of 72

As an individual, we are always eager to know how much time is needed to double our investment. We have seen long and tedious was to calculate the time where we can see our investment gets doubled. One way is using the formula of compound interest and others using excel. But these consume time in calculation.

Apart from the above methodologies, there is another quick formula which is known as the “Rule of 72”. The formula, which makes the calculation easy, is:

n = 72/r

Here, “r” is the rate while “n” is time.

Let us consider an example.

Let us assume an investor invests $1,000 in mutual fund (providing 18% interest per annum), $1,000 in a savings account (providing 4% interest per annum) and fixed deposit (providing interest of 8% per annum). Then using the “Rule of 72,” the investor can double its investment in:

  • A mutual fund in 4 years (calculation: 72/18).
  • Saving accounts in 18 years ( calculation: 72/4)
  • Fixed deposit in 9 years (calculation: 72/8)

Alternatively, if you know the time in which would want the money to grow double and we want to find the rate, then using this rule we can find the rate as well.

Suppose you want to double $10,000 in 3 years, then my rate would be:

r =  72/3

  =  24%

Interpretation: if you want to double your investment in 3 years, then your investment should grow at 24%.

Application of Rule of 72

Rule of 72 is not limited to find the time to double your money. You can use the rule in our everyday lives. Suppose you purchase a product which is currently available in $20. Now if we want to know the time in which the price of this product will get doubled, assuming the inflation rate is 5%, then what is the period. The answer would be 72/5, which is equal to 14.4 years.

In the recent past, the absolute return approach of Investing has turned out to be one of the fastest-growing investment strategies worldwide. A lot of financial advisors talk about such investments providing absolute returns. So, what exactly are the “Absolute Returns” and are they are promising? What is meant by Absolute return? Absolute return computes the increase or decrease, in an asset over a period of time, as a proportion of the original investment amount. The focus here is only on that specific asset or portfolio and not related market events. Absolute returns only consider the price movement for any specified time period. Absolute return, reckons an investment’s performance without considering the expanse of time for which investment was committed. Absolute returns can be computed for a quarter, semi- annual, annual period, 3-year duration or more. Absolute Returns are independent of Market movements and thus do not draw relative comparisons. It is one of the most commonly used investment performance metric in Hedge Funds and Mutual Funds. How to compute Absolute return? Suppose an investor Mr. Rich, invested AUD 50,000 5 years back, and the current value of his investment is AUD 75,000. The Absolute return on Mr. Rich’s investment would be 50 %, calculated using- Copyright © 2021 Kalkine Media Pty Ltd Copyright © 2021 Kalkine Media Pty Ltd So, Copyright © 2021 Kalkine Media Pty Ltd Absolute returns are just returns from point of time to other. The notion of an 'absolute return' seems very attractive to get investors’ attention as it ignores the relative market movement and promises an appreciation with zero correlation to markets. Anyhow, Absolute Return technique of computing investment yields is an apt way of calculating return on investment, predominantly in the early stages. There are numerous other types of return metrics an investor can look for later on. Major 4 types mattering most to investors being –  Absolute Return, Relative Return, Total Return & CAGR. What is the difference between Absolute Return, Relative Return, Total Return & CAGR? Absolute return refers to the gain/ loss in a single investment asset/ portfolio but to comprehend how their investments are acting relative to various market yardsticks, relative return is taken into consideration.   Relative return is the excess or deficit an asset achieves over a timeframe matched to a market index. Benchmark Return – Absolute return, gives the Relative return also called sometimes as alpha. Example, if S&P index gives a 10% return during a given period and one’s investment portfolio gives an absolute return of 12% then relative return on investment is positive/ excess 2%. Total returns take into account the effect of intermittent incomes as well as dividends. For example, in an equity investment of AUD 200 having current value AUD 240, the company also declares a dividend of AUD 10 during the year. Total returns will take into account this $10 dividend too. Thus, Total returns on the investment of AUD 200 now will be 25.00% = {(240+10-200)/200} x 100 Absolute and Total returns are easy to calculate as performance metrics, but the real challenge is when comparisons are drawn based on time period of return. Here comes in CAGR, it takes into account the term of the investment too, thus giving a more correct and comparable picture. It is computed as: CAGR (%) = Absolute Return / Investment period (equated in years) Consider for example, two investment options: One where investor earns absolute returns of 10% in 24 months and another where investor earns 5% absolute returns in 9-month duration. So, CAGR would be- For option one: CAGR = 5.00% i.e.  10%/2 (24 months/12 months is equals to 2 years) For option two: CAGR = 6.66% i.e. 5%/0.75 (9 months/12 months is equals to 0.75 years) What’s wrong with just measuring investment performance using Absolute Returns? Absolute returns will only tell an investor how much his/her investments grew by; they do not tell anything about the speed at which investments grew. When people talk about their real estate investments and say, “I bought that house for X in the year 2004. It’s worth 4X today! It has quadrupled in 17 years.” This is an application of absolute return. The drawback here is that it takes into account only the capital appreciation and doesn’t draw comparison with options having different time horizons. Investors can rely on this measure of investment performance only if they are looking for higher returns, without bothering how fast they were generated. Absolute return also doesn’t convey much about an investment compared to relative markets. Then, why do Hedge Fund/ Mutual Fund Managers choose an Investment strategy based on Absolute returns? Absolute returns should be used at times when investors are willing to shoulder some risk in exchange for a prospective to earn excess returns. This is irrespective of the timeframe and Fund administrators who measure portfolio performance in relation of an absolute return typically aim to develop a portfolio that is spread across asset categories, topography, and economic phases. They are looking for below mentioned points in their portfolios- Positive returns- An absolute returns approach of investment targets at producing positive returns at all costs, irrespective of the upside & downside market movements. Independent of yardsticks- The returns are in absolute terms and not in comparison to a benchmark yield or a market index. Diversification of portfolio- With the intention of distribution of risk, among different investment options producing positive returns in diverse ways a mixed bag of absolute return assets give a diversified investment portfolio. Less volatility- The total risk of investment is spread across the different asset held in such a portfolio. Ensuring less overall volatility in collective returns. Actively adjustable to market movements– Usually, investments look for positive returns with zero market correlation. Market shares a negative correlation with absolute return investments and vice versa. In any investment atmosphere, there are varied investment strategies and goals. Absolute return investment strategies are looking to avoid systemic risks using unconventional assets and derivatives, short selling, arbitrage and leverage. It is appropriate for investors who are prepared to bear risk for short and long-term gains.

An earnings announcement is a public statement of a company’s earnings, usually done on a periodic basis. These official announcements are released quarterly or yearly to inform the investors and the market about a company’s financial performance. Companies announce their financial reports through press releases on their websites and list them on the stock exchanges website. After the information is released through a conference call, there is a question-and-answer round with the senior management in which analysts, media, and investors can participate. On the basis of the report, analysts then incorporate earning measures such as EPS (Earning Per Share). These reports help investors in making sound investment decisions. Earnings results are announced during the earnings season on a date chosen by the company. Stock prices of the companies take a swing before and after the company releases its earnings report. Equity analysts also predict earnings estimates through their analysis which drives stock prices movement due to speculations. Stock prices even move after the earning results are declared, up or down, depending on how the results have turned out. Source: Copyright © 2021 Kalkine Media Pty Ltd. When are earning announcements made? It is mandatory for every listed company to report its quarterly financial results in the US but not in Australia. In Australia, companies release their financial report on a semi-annual basis. Having said that, many Australian companies also update their shareholders quarterly, but these are not considered official earnings. These quarterly reports are released to satisfy the market demand for information and to disclose the company’s guidance on its performance. The financial calendar varies from country to country and therefore, the earnings season changes as well. In the US, the earnings season starts after the final month of the financial quarter. Usually, American companies start posting their earnings reports in January, April, July, and October. In Australia, companies report twice a year, usually around February and August, or May and October. It depends upon the company’s financial cycle. However, whether quarterly in the US or semi-annually in Australia, these earnings results are required as agreed while listing the company with the stock exchanges. Source: Copyright © 2021 Kalkine Media Pty Ltd. Why are earnings announcements necessary? Financial results help investors, media, and other stakeholders of the company to have a greater understanding of the company’s financial footing. Companies not just provide sales, operating profit, net profits, but also offer guidance and outlook for coming months. Additionally, these reports also have senior management statements directed at the market. Therefore, earning announcements act as an informative document for the investors and analysts to study and gauge a company’s performance. Analysts can provide earnings estimates, and investors can then take wise investment decisions. These documents are also vital for companies when it comes to seeking funding for the business. Financial institutions can also judge a company’s financial health by evaluating earnings reports. The management offers insights on growth drivers, risk factors, etc that impacted the earnings during that particular period. Analysts also assess the earnings results, taking into account the external factors that drove the growth or impacted the firm negatively. These factors could be mergers and acquisitions, bankruptcies, economic discrepancies, policy changes, etc. For investors, earnings reports are essential because these announcements swing the price up or down. Traders keep a keen eye on these reports as it can be a time when they can confirm positions. However, some investors also avoid earnings seasons because of the involvement of various human factors.

What is Earnings Per Share? EPS is the per share profit by a business in a given period. While analysing a business financially, it serves as one of the basic tools. EPS is calculated by dividing profits by total shares outstanding for a given period. EPS is reported on the profit and loss statement of an enterprise and works as a denominator for beloved price-to-earnings ratio (P/E ratio), used not just by novice investors but also fund managers. A business is required to generate sustainable earnings in its life cycle, and earnings or profits are essentially among major intend of a promotor. To know more about P/E ratio read: Understanding Price-Earnings Ratio But reported earnings of a business will likely differ from actual cash earnings because devising profits mandate broader accounting standards and principles to provide a fair picture of an enterprise. EPS, therefore, becomes imperative for investors, market participants and other users of information. EPS estimates are circulated by sell-side analysts to market participants. Financial Modelling is applied to arrive at the EPS estimates of future financial years, semi-annual periods or quarterly, depending on the reporting adopted by the firm. Analyst estimates are then collected by market data providers like Reuters, Bloomberg, IRESS to provide a consensus view of analysts on the business and its financials, including revenue, operating expense, earnings before interest and tax, profit after tax, EPS. Market estimates enable participants to evaluate the expectations of sell-side analysts from a particular company, sector or even index. Analyst estimates also indicate the divergence between an individual’s expectations and collective expectations of analysts that are tracking the company. An individual can, therefore, determine whether the stock of the company is undervalued or overpriced by the market against hi one’s fair value estimates that are based on the expectations from the company. More on EPS read: What Do We Mean By Earnings Per Share (EPS)? How to calculate EPS? Although general formula considers total shares outstanding in the denominator, it is preferred to use weighted average shares outstanding over a period because companies issue new shares, buyback or cancel shares. Net Income is the profit reported by a business after incurring income tax. It is also called as Net Profit After Tax. Dividends on Preferred Shares are paid to preferential shareholders because they have first right over the income of a business, but preferred shares don’t have voting rights like common shareholders or ordinary shareholders. Weighted Average Shares Outstanding is calculated after incorporating changes in number of shares during a period, and using weighted average shares outstanding provides a fair financial position of a company. Basic V/S Diluted EPS Diluted EPS is calculated after adding the weighted average number of shares that would be issued after the conversion of dilutive shares to weighted average shares outstanding. Dilutions can include share rights, performance rights, convertible bonds etc. Whereas Basic EPS is calculated by taking weighted average shares outstanding that incorporate changes to number of shares outstanding such as buyback, new issues etc. What is Adjusted-EPS? In a financial period, firms may incur one-time expenses or transactions that are not usual in the normal course of business. The objective of adjusted EPS is to arrive at a fair picture of the business, especially for financial forecasting. Extraordinary items are excluding from EPS to arrive at adjusted EPS figure. These items can include gain on sale of assets, loss on sale of assets, merger costs, capital raising costs, integration expenses etc. What is Normalised EPS? Normalised EPS is calculated to arrive at an EPS figure, which embeds the fluctuations in income due to business cycles or industry cycles. It also includes adjustments made for calculation of adjusted EPS such as one-time gains or losses. Normalised EPS is a useful measure for companies that are sensitive to economic cycles or changes in the business environment. By smoothening out the fluctuations, it provides a fair picture of the business. If a company has reported high normalised earnings over periods, it is considered that the company is less sensitive to changes in business cycles because of its stable revenues and income during the periods. EPS and Price-to-earnings ratio Calculation of price-to-earnings ratio requires EPS as denominator and price of the stock as numerator. EPS therefore becomes a very important financial metric for investors. EPS and price data also allows participants to compare the historical trends of the P/E ratio with the current market scenario and P/E ratio of the stock. How can increase grow EPS? Businesses can increase EPS by focusing on increasing their revenue, by improving operational efficiencies either by deploying technology to reduce cost, or negotiate better prices with vendors, operate in tax efficient manner, etc. Businesses can also improve EPS by undertaking corporate action such as buying back of shares. Read: Pros and cons of buybacks – Story of 5 Popular Stocks including Aurizon Good read: Every Doubt You Have On Earnings Per Share- Explained Right Here!

What is an impairment? Impairment is accounting write off of a company’s asset, which can be an intangible asset as well as a fixed asset. An impairment loss is incurred when the fair value of the asset is lower than the carrying value in the balance sheet.  Alternatively, impairment charges can be incurred when the recoverable value of the asset is lower than the book value. Impairment charges are recorded in the income statement of the company as an expense.  Image Source: © Kalkine Group 2020 A widespread economic crisis is followed by a recession, which usually impacts the value of assets held by a company. Such events force companies to test the value of assets in the balance sheet, and this often leads to an impairment charge.  IFRS accounting standards ensure that a company’s carrying value of assets depicts a value which is not in excess of the recoverable amount.  Why are impairments charged by companies? As per the accounting rules, a business is often measured by its book value of assets. Specifically, the assets of the company carry the capability to generate future cash flows for the firm.  When the ability of an asset to deliver expected future returns is hampered, the value of assets is decreased. Therefore, it becomes an ethical responsibility of the companies to show a fair picture of the assets.  Goodwill generated at the time of business combination is required to be tested for impairments annually. Companies are required to assess any indication that could cause a potential devaluation to the asset.  When a company is holding intangible assets with an indefinite life, they are required to test the assets for impairments annually.  Cash generating units are often valued on the discounted value of future cash flows. Consequently, when market interest rates are rising, it impacts the discount rate used in estimating the recoverable amount.  Assets can be impaired because of other reasons as well. Suppose the plant and machinery of the company were damaged due to earthquake, it would result in a reduction in the value of an asset or even full write-off of the asset.  Image Source: © Kalkine Group 2020 Companies often avail consulting services to improve the performance of the business. Consultants may advise companies to shut down operations at any plant, which could result in the sale of the asset at a consideration lower than carrying value.  Oftentimes, internal reporting of the companies indicate that the performance of the asset may not yield expected benefit. This would force the management to undertake impairment testing for the asset.  Impairment vs amortisation  Amortisation is a systematic decrease in the value of an intangible asset. Amortisation of intangible assets is a process of capitalising the expense incurred on the acquisition of the asset, and then periodically recording the expense on the income statement. Impairment, on the other hand, is an irreversible decrease in the value of the asset, which is shown as an expense in the income statement. It is charged when the recoverable amount from the asset is lower than the carrying value of the asset.  Impairment vs depreciation  Depreciation is a periodic devaluation of fixed assets. It is undertaken by the companies to account for the wear and tear caused to the asset during its useful life. When a firm seeks to sell an existing asset, the buyer of the asset will deduct the depreciation from the cost of the asset before adding any premium or discount to the value for arriving at the purchase price.  Impairment on fixed assets could be related to an unusual fall in the fair value of the asset. For instance, the fair value of the machinery could be impacted significantly when a new and more efficient machine is available in the market. Similarly, an earthquake or fire can also devalue the value of the fixed asset in the balance sheet.  Reversal of impairment loss Under the reversal of impairment loss, the approach used to determine reversal is similar to the approach used in identifying the impairment loss. Reversal of impairment loss cannot be undertaken for goodwill, and it is prohibited. Companies assess whether any impairment loss recognised in the prior periods may no longer exist or have decreased. Impairment losses can only be reversed when the estimates used in determining recoverable amount are changed.  Individual asset  Previously incurred impaired individual asset can be reversed only when the estimates used in calculating the recoverable amount have changed. For instance, the changes in market interest rates could impact the discount rates used in calculating the recoverable amount.  Unless the reversal relates to a revalued asset, the reversal of impairment loss is recognised in the income statement. The revalued asset should not be more than depreciated historical cost without impairment.  Cash generating unit  In a cash-generating unit, the reversal of impairment loss is allocated on a pro-rata basis with the carrying amounts of the assets. The carrying value of an asset must not be increased above the lower of: recoverable amount and  carrying amount should have been determined without any prior impairment loss, net of amortisation and depreciation. 

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