Compound annual growth rate is a business and investing specific term for the geometric progression ratio that provides a constant rate of return over the time period. CAGR is not an accounting term, but it is often used to describe some element of the business, for example revenue, units delivered, registered users, etc. CAGR dampens the effect of volatility of periodic returns that can render arithmetic means irrelevant. It is particularly useful to compare growth rates from different data sets such as revenue growth of companies in the same industry.
CAGR - Compound Annual Growth Rate
The Compound Annual Growth Rate (CAGR) is a financial term that measures the annual rate of growth of an asset over a given time period. Calculating annual rate of growth reduces the impact of volatility of the asset. This is especially useful in comparing growth of different types of assets.
Following formula is used to calculate the CAGR of a company.
CAGR = ((Ending Value / Opening Value) (1/n) -1) x 100
where, n = the number of periods
A number of online calculators are available that can calculate CAGR of an asset. To know the CAGR of the asset, you have to enter the present value of the investment in the ending value field, the beginning value in the beginning value field, and the number of years you have held the investment asset.
Mechanics of CAGR
CAGR is a representative rate that reflects the growth that would have been achieved if the asset had increased at a steady rate. This rarely happens in real life. Most of the assets provide returns at different rates over a period of time. CAGR smooth out the growth rate that allows investors to make wise investment decisions.
A simple example can further simplify the concept. Let's suppose that you have invested $20,000 in an investment portfolio on January 01, 2014 and it increased to $30,000 by January 01, 2015 and $40,000 in January 01, 2016. In order to calculate the CAGR, you would first divide the final value of the asset by the initial value ($40,000 /$20,000). Then you would increase the resulting value (2) to the power of 1 divided by the period of investment (1/2=0.5), and then subtract from 1. Lastly you would multiply the resulting value (0.4142) by 100. This will give you the result 41.42%, which is the compounded annual growth rate of the asset.
Benefits of CAGR to Investors
CAGR reflects smoothed annualized profit rates over a variable period of time. Investors can use this metric in different ways. They can make comparisons between multiple assets to make investment decisions.
Moreover, the metric can be used by investors to better know the performance of individual assets included in the portfolio. It makes it easier for the investors to interpret return of the investment asset over a specific period. The metric can provide a broader picture of the growth of the investment.
The best part about CAGR is that it is a flexible metric. Apart from using it to measure revenue growth, it can also be used to find out growth in market share, number of users, units delivered, and forecasting future values, analyzing customer behavior, comparing historical returns, and more. Volatility in values makes arithmetic mean irrelevant. This metric smoothens out the effect of the volatility making it suitable for use in different scenarios.