What Is CAGR Or Compound Annual Growth Rate?
CAGR is a term widely used by investment gurus and market analysts. While reading a business magazine, it is not uncommon to come across statements such as, ‘Company X registered an impressive CAGR of 20% between the years of 2010 and 2013’ or ‘With a CAGR of 30.5% in 2 years, the company has shown rapid growth’. It is clear from the above financial mumbo-jumbo-filled statements that CAGR has something to do with its profit margins. By definition, CAGR is the accumulative performance of an investment over a set period. In simpler words, it is the term used to depict the ROI an investor earns annually on his or her investment over a few years. It mainly helps analysts evaluate the performance of a company.
Why It Is Important
There are myriad ways that businesses calculate their profitability. These include Annual Growth Rate (AGR), Absolute Returns, Sales Growth, and Rate of Return (ROR). But what if you want to present just one figure to your investors that represents how much your company is growing annually? That is where CAGR comes in. It gives you a representational figure showing your company’s revenue trajectory every year. As such, it is an excellent way to analyze investments, stocks and compare them. A good CAGR is a compelling way to tell your investors that it is well worth their while investing in your company’s stocks rather than in your competitors. For big-cap companies, a CAGR of 5% to 12% is considered good. For smaller cap companies, the magical range is 15% to 30%.
The CAGR Formula
The CAGR formula involves the principles of compound interest (which, according to Albert Einstein, is the eighth wonder of the world) in that both have the same components. Being a rate, the calculation is always expressed in percentage form.
Here is the formula for calculating your company’s CAGR:
CAGR = (FV/PV) 1/n – 1
FV is final or future value
PV is the present value. This value is also known as the initial value (IV)
n is number of years
To make things clear, let’s look at the example of XYZ Corp. Below is an outline of XYZ Corps’ revenue over four years, from 2016 to 2020:
CAGR = (10,000,000/5,000,000) ¼ – 1 = 18.92%
So, the CAGR for XYZ Corp between the years 2016 to 2020 is approximately 19% (well done XYZ Corp!)
Here is another example:
Rebecca invested $500 in Apple Inc. stocks for three years. Here is a breakdown of the year-end value of her investment during that time:
Let’s apply the CAGR formula to the above data:
CAGR = (3000/1000) 1/3 -1 = 44.22%
Over three years, Rebecca’s investment showed a Compound Annual Growth Rate of approximately 44%.
How To Calculate CAGR Using Our Online Calculator
If manually calculating CAGR is not your cup of tea, you can use our online CAGR calculator, which is part of our collection of financial calculators, which include calculators for calculating inflation and depreciation, among others. Our CAGR is exceptionally user-friendly. All you need to do is first input the present value, followed by the future value and the number of years. Press calculate, and you will have your CAGR percentage in no time at all.
Benefits Of CAGR
There are several benefits to using CAGR. It is more accurate than other calculations that give you a picture of your growth trajectory such as a simple mathematical average or Absolute Returns (AR). These other formulae are inherently flawed as they do not consider the crucial element of time. With its inclusion of a period, the CAGR is automatically the more precise one. For another, you can use it not only to showcase your company’s profitability but also to project future growth to your investors. Besides, since CAGR is calculated over a period and uses compound interest metrics, it is a great way to ascertain the value of a mutual fund before you invest in it.
Limitations Of CAGR
It is important to remember that CAGR is only a representational number and not a factual one. As such, it has two limitations. First, it does not reflect market reality. Like everything in life, the stock market too has its ups and downs. As we all know, these fluctuations can affect a listed company’s performance. Hence, CAGR is not a useful metric for risk assessment or analyzing market sub-trends. Second, it makes a few assumptions, namely that you are reinvesting your profits into your company and that your rate of growth has compounded at the same rate every year and will continue to do so in the future. In reality, it is a hypothetical calculation of annual growth that may or may not materialize.
CAGR is a calculation that takes all your company’s historical growth data, amalgamates them, and then reforms them into a single performance metric, making it easy to analyze and compare. However, even though it is a widely used metric in the financial world, it is not without its limitations. Since it smooths over a lot of the data, always take it with a pinch of salt. Especially for investors, the formula should be used in conjunction with other calculations such as annualized returns, trailing returns, Sharpe ratio, standard deviations, and other risk assessment metrics.