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What is CAGR?
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What Is CAGR
CAGR stands for “Compounded Annual Growth Rate” and it is a measure of an investment rate of return over a period of time assuming that all of the profits were reinvested.
The main reason why investors and financial analysts calculate CAGR is to compare different investment options over time or against a designated benchmark.
CAGR measures how much an investment would need to generate in returns to go from its initial balance at the start of a period to its ending balance at the end of the period.
The idea is to measure a theoretical and linear rate of return over the life of the investment.
CAGR can be used by businesses to evaluate different aspects of the business such as their revenue growth over a period of time, how many units they produced, how many clients they booked, and so on.
Since it is easy to calculate, many use CAGR to assess past performance or even project expected future returns from an investment option.
Keep reading as I will tell you exactly how to calculate CAGR and look at an example to illustrate the concept.
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Why Is CAGR Important
CAGR is important as it helps investors determine the rate of return based on which an investment must grow to go from its initial balance to its ending balance.
Although an investment will not necessarily perform based on the CAGR rate, this measure is still highly useful to estimate the average return an investment option can provide.
Since you’re considering the starting balance of an investment and the ending balance, you are essentially removing market volatility from the equation and assuming that the investment grows in a steady fashion over time.
Business owners, executives, accountants, investors, and others will use CAGR to compare the potential return they can expect from different investment options.
CAGR, along with different measures, can help decision-makers decide where to invest their capital.
Another reason why CAGR is important is that businesses can compare the performance of different business projects, products, or investments they are making over time.
This way, the business can get a better idea as to which segment of the business performs better than another.
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How To Calculate CAGR
Let’s see how you can calculate CAGR.
The formula that you should use to calculate CAGR is the following:
CAGR = (Ending Value / Beginning Value) ^ (1 / Number of Periods) – 1
- EV = Investment ending value
- BV = Investment beginning value
- n = Period ‘
Let’s assume that you have an investment where you need $100,000 to start and it will have an ending value of $150,000 over three years.
In this case, you will take the ending value ($150,000), divide it by the beginning value ($100,000), raise that to the power of one over three (3 years), and multiply by 100, giving you 14.47%.
This means that the investment will give you an average of 14.47% return per year during the life of the investment.
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CAGR Limitations
Although CAGR can provide useful information about the performance of an investment, it does have limitations.
The most important limitation is that CAGR does not consider market volatility during the life of the investment.
Without the volatility factor, an investor may not truly assess the potential risk of the investment.
Another limitation is that CAGR does not consider whether you have funded or withdrawn money from the investment.
You’re only looking at the starting balance and ending balance to calculate your average rate of return.
In addition, investors should be careful when measuring CAGR as the period used to assess the performance of an investment can potentially render a different result.
If an investment option did poorly in the first three years but did great in the following three years, if you measure CAGR from the 3rd year to the 6th year, your CAGR will be very high.
However, the CAGR of the entire investment from year 1 to year 6 would be much lower.
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CAGR vs IRR
Both CAGR and the IRR are used to measure the performance of different investment options.
CAGR measures the average return that you will achieve with an investment when you know the beginning and ending value of the investment and the investment term.
Although CAGR will not represent the actual performance of an investment, it provides investors a good method to objectively compare different investments.
The IRR, or internal rate return, is a more complex measure of the performance of an investment.
With the IRR, you are looking to find the discount rate at which the net present value of all of your future cash flows will be zero.
The higher an investment’s IRR, the more desirable is the investment.
The IRR is more complex as you will need to take into account all the cash flows during the life of the investment to assess its internal rate of return.
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What Is A CAGR FAQ
What is a good CAGR?
CAGR is a measure of the performance of an investment by measuring its starting value and ending value.
Naturally, the higher the CAGR, the more desirable the investment.
However, to assess what is a good CAGR, you’ll need to look at the context of the investment and your opportunity cost.
If you have an investment that gives you a 30% CAGR, it appears to be great.
However, if you had the option of investing in another project giving you a 50% CAGR, then you may no longer feel great about the first project.
Also, if a company’s revenue has grown at a CAGR rate of 5%, it may appear fairly low.
However, if the companies in the same industry had a CAGR of -10%, the first company’s CAGR turns out to be great.
What does a 10% CAGR mean?
A 10% CAGR means that an investment generates an average of 10% return over the period of time that you’re evaluating.
If you’re analyzing an investment over a 5 year period, then you are generating 10% on average per year for five years.
What is a CAGR example?
Let’s assume that a company’s revenues are the following:
- Year 1: $100 million
- Year 2: $60 million
- Year 3: $85 million
- Year 4: $130 million
If you are looking to calculate CAGR on its revenues, you will need to consider the starting value of $100 million and ending value of $130 million to calculate your CAGR over a four-year period.
In this example, the company’s revenue has grown by a CAGR of 6.78%.
However, keep in mind that CAGR does not measure volatility.
As a result, the fact that the company’s revenues had dropped to $60 million and $85 million in years 2 and 3 are not considered.
An investor should evaluate this investment further to understand why the company’s revenues have fluctuated so much over this period of time.
Takeaways
So there you have it folks!
What does CAGR mean?
In a nutshell, CAGR, or the compounded annual growth rate, is an annualized average rate of return for a given period of time.
CAGR assumes that the return of the investment or the growth is at an exponentially compounded rate.
The main advantage of CAGR is that it provides an average annualized rate of return of an investment option allowing you to compare the investment with other investment options or benchmarks.
On the other hand, CAGR does not consider the risk associated with the investment volatility during the assessed period nor does it consider changes in value caused by an investor’s actions of funding or liquidating the investment.
Now that you know what CAGR is, how it’s calculated, and why it’s important, good luck with your research!
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