What is a CAGR?

CAGR stands for Compound Annual Growth Rate, and it represents the annualized average rate of growth over a specified period. CAGR is a type of growth rate.

The Corporate Finance Institute says the following about CAGR:

“It is the measure of an investment’s annual growth rate over time, with the effect of compounding taken into account. It is often used to measure and compare the past performance of investments or to project their expected future returns.”

CAGR takes into account the compounding effect, which suggests that the growth for each year is determined using the value from the year before:

Formula

The CAGR formula is:

CAGR = (End Value / Start Value)^(1/n) – 1

Where:

  • End value is the final value of the investment or metric being measured.
  • Start value is the initial value.
  • n is the number of years or periods over which we measure the growth.

Applications

CAGR is a standardized way to measure growth over different periods and make comparisons. We can use it in various contexts, such as:

  • Investment Analysis

We mostly use it to evaluate the performance of stocks (company shares), mutual funds, portfolios, and other investments over a specific period.

  • Business Growth

Companies calculate CAGR to measure the growth of key metrics like revenue, profits, or market share. The data helps businesses determine how well they are doing and make informed decisions.

  • Industry Analysis

Analysts and researchers use it to compare the growth rates of various sectors of the economy. This helps them identify trends and opportunities.

  • Project Evaluation

We can also use it to evaluate the potential growth and economic viability of projects or initiatives.

Image illustrating the CAGR Formula.
Image created by Market Business news.

Advantages

There are several advantages to using CAGR. Let us take a look at some of them:

  • Accounts for Compounding

We can easily compare growth rates across different periods or investments.

  • Flexibility Across Durations

We can calculate CAGR for durations that span a few months, several years, or even decades – it is a very versatile metric.

Limitations and Considerations

While CAGR is a very valuable tool, it does have some limitations:

  • Assumes Consistent Growth

It assumes a constant growth rate over the specified period. This does not always happen in real-world scenarios.

  • Sensitivity to Start and End Points

The growth rate we calculate can change significantly, depending on when we start and finish measuring. This is especially true for short-term investments or those that fluctuate in value a lot.

  • Interpretation Challenges

Understanding CAGR values can be quite challenging, especially when we are comparing investments or measurements that start at different times or have varying starting values.

  • Data Quality

The accuracy of CAGR calculations depends on the quality and consistency of the underlying data we use for the calculation.

Written by Nicolas Perez Diaz