This refers to the mean annual growth rate of an investment over a certain period of time, usually longer than one year. It can be explained as a measure of growth of an investment based on the assumption that the investment grows in terms of value on a steady rate, compounded annually.
The compound annual growth rate value gets an investor from the initial value of an investment to the final value of the investment over a specified duration of time. However, this is only a hypothetical value which does not account for volatility. The calculation of the compound annual growth rate for an investment is easy provided that the present value and expected future value of the investment are known, as well as the duration (years) in which the investment attains the future investment value.
Uses of CAGR:
CAGR can be used to calculate the average growth of a single investment. Because of market volatility, the year-to-year growth of an investment may be difficult to interpret. For example, an investment may increase in value by 8% in one year, decrease in value by 2% the following year and increase in value by 5% in the next. With inconsistent annual growth, CAGR may be used to give a broader picture of an investment’s progress.
CAGR may also be used to compare investments of different types with one another. For example, suppose in 2010 you put $10,000 into a savings account with a fixed annual interest rate of 1%, growing to a value of $10,100 in 2011, $10,201 in 2012 and $10,303.01 in 2013. Say that in 2010, you wanted to pursue other investment options but, fearing market volatility, you only invested $5,000 this time, into a portfolio with a varying growth rate. Suppose that the portfolio grew in value to $5,114 in 2011, dropped to a value of $5,098 in 2012 and grew to $5,437 in 2013. Although the portfolio grew at an inconsistent rate and even lost value in 2012, the investment’s CAGR between 2010 and 2013 was 2.83% ((5,437/5,000)^(1/3) – 1 = 1.0874^0.3333 – 1 = 1.0283 – 1 = 0.0283 = 2.83%), substantially higher than the interest rate of the savings account. The portfolio, then, proved to be the more profitable investment.
CAGR can also be used to track the performance of various business measures of one or multiple companies alongside one another. For example, over a five-year period Big-Sale Stores’ market share CAGR may be 1.82% but its customer satisfaction CAGR over the same period might be -0.58%. In this way, comparing the CAGRs of measures within a single company may reveal that company’s strengths and weaknesses. However, comparing those CAGRs with those tracking the same measures in other companies may help situate this data within the scope of the market. For example, Big-Sale’s customer satisfaction CAGR might not seem so low if compared with SuperFast Cable’s customer satisfaction CAGR of -6.31% during the same period.
Limitations of ‘Compound Annual Growth Rate – CAGR’:
One of the greatest limitations of the compound annual growth rate is that it ignores volatility. In reality this is never the case and thus it is not advisable to use CAGR as the only metric to determine the growth rate of an investment. The compound annual growth rate cannot also be considered as a reliable forecast of growth because no matter how steady the growth rate of an investment has been in the past, it is not guaranteed that this will be the case in the future because of other factors in the market that affect the growth rate of an investment.