One of the most powerful components of investing is compound growth. This is a natural phenomenon that can be summed up as growth on top of growth.
For example, if you have $10,000 in an investment that grows by 10% one year, that gives you a $1,000 gain. Now, if your portfolio is at $11,000 ($10,000 + the $1,000 gain), and it grows by another 10%, you gain $1,100 instead of $1,000, since you’re starting from a higher base value.
Over two years, you would have gained $2,100 from that $10,000 investment, which is 21% — higher than the 20% result you’d get if you simply added the 10% annual return numbers for each of those two years. That’s because the 21% accounts for compound growth, and if you want to turn that into an annual figure to get a better sense of growth (compared to the 10% regular average, known as the arithmetic average), then you could use a metric known as the compound annual growth rate (CAGR).
Here is a closer look at what does CAGR mean, particularly in terms of what does CAGR mean in business and the CAGR meaning in finance.
CAGR is a formula that calculates how the value of an investment has changed over the course of a specific time period, assuming all earnings have been reinvested and no deductions have been made.
This calculation allows investors to determine overall performance by examining how much an investment has gained or lost over multiple years. It can be a useful tool for comparing multiple investments to see what might be worth buying, whether it’s securities, property, a business, or anything else of value.
CAGR is a measurement of annual growth over a given period that accounts for compounding returns. It does not show what the actual returns were each year, but it instead provides an average based on the starting and final values over a specific period, assuming that any returns have been reinvested.
Simple growth rate looks at the total return based on starting and ending values, without accounting for compounding or reflecting an annual growth rate. Meanwhile, CAGR shows the average annual growth rate, factoring in compound growth.
For example, simple growth rate might show that a business grew revenue by 100% over five years, from $100 million to $200 million. CAGR doesn’t just divide that by five to show a 20% annual growth rate, because returns don’t work that way due to the effects of compounding. Instead, CAGR would be 14.87% (see the next section for how to calculate CAGR).
While CAGR might suggest that returns were lower than the simple growth rate suggests, they both lead to the same total result. CAGR simply reflects what the annual growth rate averaged out to over the period, accounting for compounding. If you didn’t account for compounding and just divided that 100% gain by five years, the average annual growth rate (AAGR) would be 20%.
CAGR is calculated by looking at the initial and final values of an asset over some time to evaluate performance or growth in value. This formula is relatively simple and assumes that any value earned or revenue — such as through interest or dividends in the case of financial securities — has been reinvested and compounded into the investment.
“The CAGR measure can be used in any industry,” explains Daniel Garza, Chartered Financial Analyst and Manager, Research Team at Corient. “However, it can be used in the investment world to complement other widely used measures, such as time-weighted return. This is because some assets are not publicly traded and it’s harder to know their value at a specific time every month/year to evaluate growth or rate of return.”
Garza says that CAGR is useful when applied to assets that don’t have publicly available data to determine performance, such as property or physical assets.
“This is because having an initial value for a physical asset and a final value for the same asset, regardless of the timeframe, allows you to calculate it,” he says. “There is no need to constantly know the value of this asset to get to CAGR.”
To calculate CAGR, use the following formula:
Let’s see how this works when you put it all together. To keep things simple, we will determine the CAGR for an investment that has grown from $100 to $108 over five years. Your formula would look like this when you plug in all of the values:
CAGR = (108/100)^⅕ -1 = .015511 or 1.5511%
This tells us that, on average, the investment gained 1.5511% in value each year during the selected five-year period. Some years may have seen more growth and others less, but the trend smooths out to this rate when you look at the timeframe as a whole.
There are many CAGR calculators available online but you can also use Microsoft Excel. The program’s XIRR function will calculate CAGR after you input the relevant values and dates. This can save a lot of time and get you a quick calculation, taking some of the legwork out of your research.
One of the most common reasons investors use CAGR is to compare investments. Though you’re not seeing the actual gains and losses from year to year, CAGR shows you how an investment has historically performed. You can use this information to learn about one or more investments, see how they measure up to one another, and make more informed decisions about where you want to put your money.
Using CAGR in investment analysis is particularly helpful by showing the effects of compound returns. It gets tricky when talking about it theoretically or doing the math in your head, but the power of compounding makes a big difference in total returns. So, if you can compare two investments based on CAGR, you can potentially make a more accurate analysis of potential future gains, though keep in mind that past performance is never a guarantee of future results.
You can also use CAGR to track business performance as a result of measures a company takes, such as policy changes or new products introduced to the market. It can also give you an idea of a business’s strengths and weaknesses. For example, a CAGR that shows a steady decline over a number of years might indicate that internal or external issues are impacting profitability and the business is struggling to overcome them.
Although CAGR can be useful for investment analysis or analyzing business performance, CAGR isn’t a perfect metric. Some limitations of CAGR include the following:
CAGR is a simplified, overall look at past performance. If you want to make a more robust analysis of investments, portfolios, businesses, etc., you might use alternatives such as:
Looking at the CAGR of an investment can be useful in evaluating past performance. Because it assumes that growth is consistent from year to year within the evaluation period, it may not accurately reflect the volatility an investment experiences. It’s a smoothed average that doesn’t tell the whole story but can be used to quickly compare how different investments stand up to each other when accounting for compound growth.
You’ll find CAGR applied to all kinds of industries and to just about anything of value. Make sure to fully understand the context of how CAGR is calculated so you can make an informed opinion about what it means for your goals.
And remember that while this average uses data based on events that have already taken place, it is not necessarily an accurate predictor of how an investment will perform moving forward. View it as one of many data points in your larger research about opportunities you’re interested in investing in.
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The CAGR acronym stands for compound annual growth rate. It is a measure of annualized growth over a given period when accounting for compound returns.
A good CAGR varies greatly based on what you’re comparing, such as investment returns or corporate financial performance, aside from stock prices. For large, mature businesses, for example, a CAGR in the ballpark of 10% could be considered a good rate for revenue growth, whereas an emerging company might be expected to have a CAGR of around 25%+.
To calculate CAGR in Excel, you can use the program’s XIRR function after entering the relevant values and dates.
CAGR accounts for compound growth, while an annualized return may or may not account for compounding, depending on the context.
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