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Understanding how your investments or business projects grow over time can sometimes feel like trying to read a map without any landmarks. You know there's growth, but how exactly do you quantify it?
Compound Annual Growth Rate (CAGR) offers a simple yet powerful way to measure and understand the growth of your financial ventures over multiple periods.
CAGR smooths out an investment's growth rate as if it had grown steadily each year—despite actual fluctuations along the way. It's like planting a tree and measuring its height only when you plant it, and then five years later; CAGR tells you how much that tree grew each year, on average, accounting for natural growth spurts and slower periods.
In this article, you'll learn what CAGR really means, why it matters in evaluating business performance, and how to calculate it step-by-step.
What is CAGR and why is it important?
CAGR stands for Compound Annual Growth Rate. It shows you how fast an investment has grown each year over a certain time. Think of CAGR as the path your investment takes from start to finish, ignoring all the bumps along the way. CAGR or compounded annual growth rate smoothens out volatility to present a clear picture of investment growth over time.
This makes it useful because it tells you one steady rate of growth, even if the actual yearly growth was up and down.
Unlike simple growth rates that just look at the beginning and end, calculating CAGR means providing an annual rate that flattens out the volatility and displays the mean annual growth as if the growth has been consistent each year.
This gives you a clearer picture of how your investments are really doing over time.
How to calculate CAGR
Understanding the CAGR formula and how to apply it is vital for tracking investment growth over time.
Here's how you can calculate CAGR step by step:
- Identify your starting value: This is where your investment begins its journey. It could be the initial amount of money you put into an investment fund or the market value of a stock when you first bought it.
- Determine your ending value: Look at where your investment stands now or at the end of its period. This figure will show how much it has grown or shrunk over time. Determining the future value of the investment is a key step in the CAGR calculation.
- Determine the period: Count the number of years between when you started and ended your investment. If it's not whole years, that's okay – just count it as a fraction. The number of years or the investment period is another essential metric for calculating CAGR accurately.
- Plug these numbers into the CAGR formula: Use CAGR = (Ending Value / Starting Value)^(1 / Number of Years) – 1.
- Multiply by 100 to get a percentage: Because we talk about growth rates in percentages.
So, say you invested $1,000 in a fund (your starting value), and after five years, it grew to $1,610 (your ending value). You would plug those numbers into our formula like this:
- CAGR = ($1,610 / $1,000)^(1 / 5) - 1
and discover that your CAGR is 0.10, or 10% when we convert it to a percentage.
If you want a quick calculation of your CAGR, you can also use this CAGR calculator.
How to calculate CAGR in Excel
Inputting the CAGR formula in Excel is a straightforward way to see how investments grow over time. You can use two functions, RATE or RRI, depending on your preference.
Using the RATE Function
- Open Excel and type in your investment's beginning value (PV) in one cell.
- Type the ending value (FV) of your investment in another cell.
- Count how many years (n) your investment will grow. Type this number in a separate cell.
- Click on an empty cell where you want the CAGR result to appear.
- Enter the formula: ‘=RATE(n,, -PV, FV)’. Make sure to reference the cells where you typed PV, FV, and n.
Using the RRI Function
- First, make sure you know your investment's starting value, final value, and duration in years.
- In Excel, place these values each in their own cell.
- Find an empty cell to display your CAGR result.
- Type the formula: '=RRI(n, PV, FV)' into this cell. Again, refer back to where you placed PV, FV, and n.
Both methods will give you your investment's compound annual growth rate directly in Excel without needing extra tools or calculations by hand. Choose whichever function you find easier or suits your needs better.
Compound Annual Growth Rate example
Now that you've seen how to calculate CAGR, let's use this tool with real examples. Imagine a company called Tech Innovations increased its revenue from $100 million in 2018 to $200 million in 2023.
To find out the CAGR, use the formula: CAGR = (Ending Value / Starting Value)^(1 / Number of Years) – 1. Here, ending value is $200 million, starting value is $100 million, and number of years is 5.
This gives us a CAGR of about 14.87%. It means Tech Innovations grew its revenue by an average rate of nearly 15% each year over the five-year period. This CAGR is indicative of the company's revenue growth, highlighting its success in expanding its business.
For market share expansion, assume another company named Health Corp saw its market share increase from 10% to 20% over three years. Using the same CAGR formula where now your ending value is 20%, starting value is 10%, and time frame is three years – we discover Health Corp's market share grew by roughly 25.99% annually during this time.
Comparing these growth rates across industries lets you see which sectors are expanding faster. For example, if technology generally shows higher CAGRs than healthcare over several comparisons like ours above, it could signal tech as a more rapidly growing sector overall.
What is a good CAGR?
A good CAGR depends on where a business is in its life cycle and what industry it's in. For start-ups, high growth rates are usual. They might see CAGR numbers in the double digits, showing rapid expansion.
Established companies, on the other hand, often have lower CAGRs. This is normal because they're already large and can't keep growing as fast.
Every industry has its own standard for what a strong CAGR looks like. Tech sectors might expect higher growth rates due to quick changes and innovation. Traditional industries like manufacturing may see steadier but slower growth rates as normal.
Using CAGR to compare your company's growth with others in the same field is smart. It helps you see if you're keeping up or falling behind. Remember, knowing your industry average gives context to your numbers and can guide strategies for improvement or change.
Advantages of CAGR
CAGR makes it easy to see how your investments or business has grown over time. It turns complex numbers into one simple growth rate you can discuss clearly. This single rate shows the real picture of yearly growth, flattening out ups and downs along the way.
By providing a standardized metric for comparing investments and growth, CAGR enables informed strategic planning and decision-making by evaluating long-term performance and identifying industry trends.
Disadvantages of CAGR
CAGR also has its downsides. One issue is it can hide the ups and downs in an investment's journey. On paper, CAGR smooths out the growth over the years as if it's steady. But in reality, stocks or funds might have faced big risks or sudden drops that this number doesn't show you. Since CAGR does not take into account the investment risk, it can significantly affect the interpretation of investment growth.
Also, CAGR acts like all your earnings get put back in at the same growth rate every year. That sounds great, but isn't always true outside of calculations. Sometimes, you can't reinvest profits that way because rates change or you need cash for other things.
And lastly, not everything fits well with a CAGR lens. If your money flow isn't consistent—like some years are high and others low—CAGR might not give you the complete picture on how good (or bad) things are going.
CAGR vs. IRR
CAGR and the Internal Rate of Return (IRR) are both critical in financial analysis, yet they cater to different scenarios. CAGR calculates an investment's average annual growth rate, while the IRR estimates profitability of potential investments by setting the net present value of cash flow to zero.
Some key differences include:
CAGR vs. growth rate
CAGR and annual growth rate are similar. Both serve as indicators of growth over time, yet they diverge in their calculation methods and the insights they offer.
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