What is CAGR?
The Compound Annual Growth Rate (CAGR) is the annualized rate of growth in the value of an investment or financial metric, such as revenue, over a specified time period.
The conceptual meaning of CAGR can be conceived as the hypothetical growth rate as if all changes occurred evenly at the same rate over each individual period, i.e. the CAGR metric effectively “smoothens” the growth rate.
How to Calculate CAGR (Step-by-Step)
The compound annual growth rate, or “CAGR”, is the rate of return required for the value of an investment or financial metric to grow from its beginning value to its ending value between two dates.
Conceptually, the CAGR metric answers the following question, “At what growth rate must the metric grow at each [Period] to reach [Ending Value] from [Beginning Value] under the time frame of [Number of Periods]?”
The three inputs necessary to compute the CAGR are listed below.
- Beginning Value
- Ending Value
- Number of Periods (t)
The process of calculating the CAGR can be broken into the following three steps:
- Step 1→ Divide the Ending Value by the Beginning Value (i.e. Initial Value)
- Step 2 → Raise the Resulting Figure to the Inverse Number of Compounding Periods (1 / t)
- Step 3 → Subtract One to Convert the Implied CAGR into Percent Form
The formula for calculating the compound annual growth rate (CAGR) is as follows.
- Ending Value → The final value at the end of the period (EoP).
- Beginning Value → The initial value as of the beginning of the period (BoP).
- Number of Periods (t) → The total number of compounding periods.
Quick CAGR Calculation Example
Suppose there is a company with revenue of $20 million at the end of the current period (Year 0).
Five years from the present date, the company’s revenue is projected to reach $32.5 million (Year 5).
Given those assumptions, we’ll enter the following figures into the CAGR formula:
- Beginning Value = $20 million
- Ending Value = $32.5 million
- Number of Periods = 5 Years
In the first part of the formula, the ending value of $32.5 million is divided by the starting value of $20 million.
The resulting figure must then be annualized by raising it to the power of 1 divided by the 5 periods.
Lastly, once we subtract 1 from the return value, we are left with a CAGR of 10.2%.
- Compound Annual Growth Rate (CAGR) = ($32.5 million ÷ $20.0 million)^(1 ÷ 5 Periods) – 1 = 10.2%
Note: Year 0 is excluded when counting the number of periods because only the periods when the revenue is compounding must be counted. Thus, we subtract the beginning period number from the ending period number (i.e. Year 5 minus Year 0 = 5 Years).
What is a Good CAGR?
The most notable benefit of the compound annual growth rate (CAGR) metric is the relative ease at which it can be computed, while still providing valuable insights into the growth profile of anything that rises (or falls) in value.
The financial performance of a particular company (e.g. revenue growth, EBITDA growth) or the investment performance of a portfolio can be measured using the CAGR, which reflects the versatility of the metric.
Because the CAGR can confirm whether the projections align with the industry average and historical growth, the CAGR metric can also be useful as a sanity check, i.e. to confirm the assumptions are reasonable.
Suppose a company’s revenue is projected to grow at a CAGR of 20% but the company’s closest comparables are expected to grow around 5% while the collective industry is being forecasted to grow 3% across the same periods.
Here, the company’s growth assumptions would likely warrant adjustments of some sort, or at the very least, a closer look into whether the numbers are reasonable or not.
Since annualized growth metrics remove the fluctuations of year-over-year growth rates, this helps facilitate the comparisons of CAGR over time between two companies or investments, which would otherwise be very challenging to compare.
The main drawback to the CAGR is that it fails to take into account the volatility associated with the underlying asset. Thus, the growth metric becomes vulnerable to misinterpretations, as the actual growth rate experienced year-over-year may vary.
For instance, a company’s revenue growth could in reality be disproportionate, with positive growth being front-ended in the earlier periods and ultimately tapering off or even flattening.
In the absence of understanding the contextual details of the specific scenario on hand, the CAGR can be misleading by erroneously portraying the company as having consistent positive growth potential.