Guide to compound annual growth rate: CAGR formula, benefits & limitations

What is a compound annual growth rate?

Compound annual growth rate (CAGR) measures an investment or financial metric's annual growth rate over a set period of time that's longer than a year. This growth rate accounts for the reinvestment of profits at the end of each financial period.

Compound annual growth rate (CAGR) formula

CAGR is an invaluable tool for an organization or investor to accurately determine returns for investments and individual assets. The formula for calculating compound annual growth rate is as follows:

CAGR = (Ending value/beginning value) ^ (1/No. of periods) -1

Where:

• EN-Ending value
• BV-Beginning value
• N-Number of compounding periods

How to calculate compound annual growth rate

When calculating CAGR, begin by dividing the investment's value at the end of the period by its value at the start of the period. Then, raise the result to the power of one divided by the number of years. From there, you'll subtract one from the result you get and multiply it by 100 to convert the answer into a percentage. 

Along with the CAGR formula, it's also essential to know how to calculate the internal growth rate (IGR). This refers to the highest level of growth your company can achieve without external financing. It's a key metric, especially for startups and small businesses, as it represents the ability to increase profit without incurring debt or issuing more stock.

The formula for calculating IGR is as follows:

IGR= ROA *r/ (1-ROA*R) 

Where:

• ROA (Return on Assets) = Net income / Total Assets
• r (Retention Rate) = Reinvested Earnings / Net Income or 1 – Dividend Payout Ratio

Why calculate CAGR

There are some key things that you should note about the compound annual growth rate. First, it is not a representation of the actual rate of return or future value. It only serves as a method of forecasting the rate at which an investment may grow if it maintains the same growth rate over the entire forecast period. Moreover, the profits at the end of each accounting period within the set timeframe should be reinvested. 

Nonetheless, calculating CAGR offers benefits such as:

1. Determining the value of an investment

Over time, the value of an investment will change. This is caused by fluctuations in the rate of growth or revenue growth. Either way, it's important to have a clear picture of what an investment's value is or what it's going to be at a later date.

In this regard, calculating the compound annual growth rate will help. It will give you insight into the investment's present value and allow you to make sound business decisions.

2. Comparing different investments

There are plenty of investment vehicles to choose from as an investor. The investment risk and interest rate varies with each. To choose the one that suits you, it's essential that you know what to expect from all available options.

By calculating the CAGR for each vehicle, you'll know the average return to expect during the investment period. With this information, it will be easier to compare different investments and determine the best one.

3. Analyzing historical returns

Understandably, your primary focus will be on potential earnings when making investment decisions. However, it's equally important to review the historical performance of an investment to determine whether projections are realistic.

When it comes to calculating the performance of investments over time, CAGR is the best formula. Moreover, it helps address the limitations of the arithmetic return. Therefore, you can use CAGR to analyze the historical returns of mutual funds, stocks, and savings accounts. 

4. Tracking business performance and forecasting revenue growth

Aside from overall organizational growth, you can use CAGR to track the performance of specific business metrics. Once you know how these metrics perform, you have a basis for comparing them against each other.

In turn, this allows you to predict overall business performance and make revenue projections more accurately. Moreover, it puts you in a good position to achieve hypergrowth. 

5. Discovering business strengths and weaknesses

Given the competitive nature of the business ecosystem, you cannot afford to have any organizational vulnerabilities. By comparing the CAGR of specific business activities with those of similar organizations, you can determine your company's weaknesses and strengths. 

CAGR limitations to keep in mind

While CAGR offers many benefits, it's important to keep in mind that it also has some limitations. These include:

1. It doesn't account for investment volatility

When calculating the compound annual growth rate, you'll use a smoothed rate of growth over the period in question. However, this can be a major limitation. While you may want your industry and company to grow steadily and predictably, that's rarely ever the case, much less so for an extended period.

Due to volatility in the market, the annual rate of growth will vary in each financial period. For instance, your growth rate for the first year may be 15% only for it to fall to 8% in the next year. With the exception of bonds that have a fixed return until maturity, the growth rate of all other investments will vary each year.

2. It doesn't account for added funds in an investment portfolio

For CAGR calculations to remain accurate, there are some key actions your company will need to take. First, you should not withdraw your initial investment. Second, all the profits for the set number of years should be reinvested. 

So, if you withdraw or add funds to the investment during the forecasting period, the CAGR calculations will not be accurate. Increasing your investment will inflate the CAGR while withdrawing funds will reduce it. 

3. It can only be used to compare identical time periods

CAGR is a great tool for comparing the performance of investments or key business metrics. However, since CAGR is calculated based on a particular timeframe, you can't make comparisons for different periods. 

4. It is less reliable for shorter investment periods

CAGR provides accurate forecasts on the annualized rate of growth for investments or specific metrics. To get accurate results, it's better to use extended periods when calculating compound annual growth rates.

Regardless of how steadily growth has been in the past, you cannot account for volatilities. As such, if you calculate the CAGR for two years and there's a disruption in the second year, it will significantly affect the CAGR. However, if you increase the number of years to five, the disruption in the second year will only make a minor dent in the formula's accuracy.

What is a good compound annual growth rate example?

You'll want each investment to have a desirable compound annual growth rate. However, this number varies depending on the circumstances surrounding each investment. 

For instance, suppose the CAGRs of two investments are 20% and 25%. At first glance, the latter percentage seems better. However, if the industry CAGRs for both are 10% and 30%, respectively, the outlook will change. This is because the latter investment is performing below industry level while the former is well above the industry standard.

Moreover, if the risk for the investment with higher returns is significantly higher, the one with lower returns may become more appealing. As you can see, it's not just about CAGR values, but also the unique circumstances that surround each one.

Compound annual growth rate FAQs

Given the benefits of calculating CAGR, it's understandable if you have some questions. See the list of frequently asked questions and responses for some clarity:

1. What is the difference between an AAGR vs. CAGR?

While they're similar, AAGR and CAGR are different metrics. AAGR provides the numerical average of annual growth rates. On the other hand, CAGR is the average compounded growth rate for the set duration of time.

2. What is the difference between CAGR vs. IRR?

Both CAGR and internal rate of return (IRR) measure the performance of an investment. However, CAGR does so for a certain period of time while IRR is more flexible. As such, IRR is much better when tracking the performance of investments with different cash inflows and outflows.

3. What is the difference between CAGR and growth rate?

When calculating CAGR, you have to account for compounding. However, growth rate is a linear measure that does not factor in compound growth. 

4. What is risk-adjusted CAGR?

This refers to CAGR calculations that include the degree of risk that you must accept for the CAGR to be achieved.