Compound Annual Growth Rate, or CAGR, is a powerful tool used by investors, analysts, and business leaders to measure the growth of an investment or business over time. It is considered a basic tool for reliably gauging the growth of an entity or security.
While simple growth rates can provide a quick snapshot of an investment’s performance, the compound annual growth rate provides a more comprehensive picture of its growth trajectory. Through it, market participants are better informed and can act accordingly.
Whether you are a seasoned investor, a financial analyst, or a business leader, understanding CAGR is essential for making informed decisions about your investments or company’s growth strategy.
In this article, we will explore the concept of compound annual growth rate in depth, including its calculation, interpretation, and real-world applications. By the end of this, you would have a strong idea of what the tool entails, along with its merits and demerits.
What Is CAGR In Finance?
The basic problem when measuring the growth of a particular metric such as revenue, stock price, or enterprise value is the fact that growth fluctuates year by year. Calculating a simple average does not solve the problem either as it does not consider annual fluctuations.
This is where compound annual growth rate comes in, a metric that accounts for growth rate changes each year, and gives a single growth rate over a specific horizon.
When applied over the entire period, this growth rate would result in the same final value as the actual growth rates. As such, it reduces the complexity of analysis and gives the users of information all they need to know about growth, in a single figure.
It can be a useful way to compare the growth of different investments or businesses over the same period of time.
CAGR Use Cases
Now that we have a general idea of exactly what is CAGR we can turn towards its use cases, in order to determine how valuable it is, as a tool, to market participants. Its primary uses are listed below as follows:
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Projecting Future Growth
The compound annual growth rate can be a valuable tool for predicting future growth rates based on past performance.
It allows one to use a single growth rate to make an educated guess about how much growth can be expected in the future, assuming the same growth rate continues.
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Investment Analysis
When comparing the track record of different securities in the market, the compound annual growth rate is one of the foremost ways to assess which one fares better in the market in terms of overall growth.
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Internal Business Performance Analysis
Managers of companies also turn to the compound annual growth rate to assess the business performance of metrics such as revenue, income, cash flow, and others. It is also highly useful for goal setting and internal benchmarks.
Advantages Of Using The CAGR
The compound annual growth rate offers several benefits that make it a popular tool for stock analysis and other financial measurements. Below are some of its key advantages:
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Simple Interpretation
The simplicity of the compound annual growth rate is what sets it apart from most growth measurements. It delivers a single figure that gives a complete picture over a particular time horizon.
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Easy Calculation
The compound annual growth rate is a simple and easy-to-calculate measure that does not require complex computations or advanced financial knowledge.
It only requires knowledge of the starting and ending values of an investment, as well as the length of time over which the investment grew.
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Strong Tool Of Comparison
The compound annual growth rate is a useful tool for comparing the performance of different investments over the same time period.
It allows investors to compare the growth rates of different investments on an equal basis, regardless of their starting or ending values.
Disadvantage Of CAGR
Where the compound annual growth rate boasts a number of strengths, it is important to not be blind-sided by some of its weaknesses. Listed below are some disadvantages of this measurement tool:
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Overly Simplistic
The simplicity of the compound annual growth rate can also be taken as one of its most obvious shortcomings. It essentially ignores volatility by returning a single figure, which may not portray a complete picture to its users.
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Potentially Inaccurate Assumptions
In certain cases, the assumptions of compound annual growth rate can be described as questionable. This is especially true in the case of negative growth where the tool assumes steady growth.
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Limited Outlook
Because the data that is used to derive compound annual growth rates is limited to a particular period, it may not be sufficient to reliably draw projections. This is especially true in the case of highly volatile markets with uncertainty.
How to Calculate CAGR
When exploring what is CAGR in stocks, it is important to discuss the manner in which it is calculated. As mentioned above, the calculation is relatively simple, with the formula expressed below as follows:
The computation above may seem complex initially but is actually a fairly simple calculation that requires merely three inputs. These are as follows:
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Initial Value
This would be the starting value from which point a growth rate is to be calculated. In the case of stocks, this would be the price at the beginning of one’s investment horizon.
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Final Value
This part of the calculation inputs the final value up to which growth has been observed. It would be the value at the very end of the investment horizon and would point to the maximum growth attained.
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N (Number Of Time Periods)
N reflects the number of time periods that are involved in the calculation. Because the growth rate is typically calculated over several years, N usually denotes the number of years in a particular investment horizon.
What Is A Good CAGR?
The next logical question one would ask when looking into ‘what is CAGR?’ would be ‘what is a good CAGR?’ To address this, it must be clarified that good compound annual growth depends on the investment in question and its associated risks.
In general, a higher compound annual growth rate is considered positive, as it reflects a higher rate of return. However, a high rate can also indicate higher risk and volatility in certain situations.
In general, when asking one’s self what is a good CAGR, it is important to note the inherent differences in various investment classes. It is essential to consider an investment’s risk profile, historical performance, and future potential while evaluating the appropriateness of its CAGR.
For instance, a good CAGR for a low-risk investment like bonds may range between 3% to 5%, while a good CAGR for a high-risk investment like a startup company may range between 20% to 30%.
Example Of How To Use CAGR
In order to best contextualize compound annual growth rate it would be appropriate to present it in light of an example.
We assume an investor bought Apple Inc. (NASDAQ: AAPL) stock worth $1,000 in 2013. At the start of 2013, AAPL was priced at $16, whereas presently it is priced at almost $160. So compound annual growth rate can be calculated with the following inputs provided:
- Initial value = $16
- Final value = $160
- N = 10 years
On the basis of the information presented above, the compound annual growth rate, by use of the formula, works out to be approximately 26.9%. This represents the average growth rate AAPL experienced in each of the last 10 years to get it to its current price.
Although the year-on-year growth has been volatile and has differed quite significantly from the derived figure of 26.9%, this gives a simplistic overview for anyone looking into the average growth rate of the company’s stock.
Conclusion
Understanding what is CAGR in finance is crucial for investors and analysts alike as it provides a highly simple yet strongly reliable measure of an investment’s growth rate over a specified period.
Compound annual growth rates can be used to compare different investments and evaluate their performance in a meaningful way. However, it is important to keep in mind that the metric assumes a steady rate of growth, which may not be the case in reality.
Despite all the strengths of the compound annual growth rate, it is essential to supplement it with other metrics and perform a thorough analysis before making any investment decisions.
FAQs
What Is The Difference Between CAGR And IRR?
CAGR is a measure of the constant growth rate of an investment over a specified period, while IRR is a metric that calculates the internal rate of return of an investment based on its cash flows.
What Is The Difference Between The CAGR And A Growth Rate?
While both Compound Annual Growth Rate and growth rate look into growth, CAGR takes into account the effect of compounding, while a standard growth rate does not. As a result, the compound annual growth rate is a more accurate representation of growth over time.
What Is Risk-Adjusted CAGR?
Risk-adjusted CAGR is a financial metric that adjusts the CAGR for the level of risk associated with an investment. It is used to compare the performance of different investments that carry different levels of risk.