CORPORATE FINANCE & ACCOUNTING FINANCIAL RATIOS

Compound Annual Growth Rate –

CAGR
By JASON FERNANDO | Reviewed by JULIUS MANSA | Updated Mar 1, 2021

TABLE OF CONTENTS
What Is Compound Annual Growt… Formula and Calculation of CAGR
What CAGR Can Tell You Example of How to Use CAGR
Additional CAGR Uses Investor Use of CAGR
Modifying the CAGR Formula Smooth Rate of Growth Limitation
EXPAND +
Other CAGR Limitations CAGR vs IRR

What Is Compound Annual Growth Rate – CAGR?

Compound annual growth rate (CAGR) is the rate of return that would be required
for an investment to grow from its beginning balance to its ending balance,
assuming the profits were reinvested at the end of each year of the investment’s
lifespan.
Formula and Calculation of CAGR

CAGR = ( ) −1
EV n
BV
where:
EV = Ending value
BV = Beginning value
n = Number of years

To calculate the CAGR of an investment:

1. Divide the value of an investment at the end of the period by its value at the
beginning of that period.
2. Raise the result to an exponent of one divided by the number of years.
3. Subtract one from the subsequent result.

KEY TAKEAWAYS
CAGR is one of the most accurate ways to calculate and determine
returns for anything that can rise or fall in value over time.
Investors can compare the CAGR of two alternatives in order to evaluate
how well one stock performed against other stocks in a peer group or
 how well one stock performed against other stocks in a peer group or
against a market index.
CAGR does not reflect investment risk.

What CAGR Can Tell You

The compound annual growth rate isn't a true return rate, but rather a
representational figure. It is essentially a number that describes the rate at which
an investment would have grown if it had grown the same rate every year and the
profits were reinvested at the end of each year. In reality, this sort of performance
is unlikely. However, CAGR can be used to smooth returns so that they may be
more easily understood when compared to alternative investments.

Example of How to Use CAGR

Imagine you invested $10,000 in a portfolio with the returns outlined below:

From Jan 1, 2014, to Jan 1, 2015, your portfolio grew to $13,000 (or 30% in
year one).
On Jan 1, 2016, the portfolio was $14,000 (or 7.69% from Jan 2015 to Jan
2016).
On Jan 1, 2017, the portfolio ended with $19,000 (or 35.71% from Jan 2016 to
Jan 2017).

We can see that on an annual basis, the year-to-year growth rates of the
investment portfolio were quite different as shown in the parenthesis.

On the other hand, the compound annual growth rate smooths the investment’s
f di h f h 2014 d 2016 diff f 2015
performance and ignores the fact that 2014 and 2016 were so different from 2015.
The CAGR over that period was 23.86% and can be calculated as follows:

( $19,000 )
3
CAGR = $10,000 − 1 = 23.86%

The compound annual growth rate of 23.86% over the three-year investment
period can help an investor compare alternatives for their capital or make
forecasts of future values. For example, imagine an investor is comparing the
performance of two investments that are uncorrelated. In any given year during
the period, one investment may be rising while the other falls. This could be the
case when comparing high-yield bonds to stocks, or a real estate investment to
emerging markets. Using CAGR would smooth the annual return over the period
so the two alternatives would be easier to compare.

Additional CAGR Uses

The compound annual growth rate can be used to calculate the average growth
of a single investment. As we saw in our example above, due to market volatility,
the year-to-year growth of an investment will likely appear erratic and uneven.
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. CAGR
helps smooth returns when growth rates are expected to be volatile and
inconsistent.

Compare Investments
CAGR can be used to compare investments of different types with one another.
For example suppose in 2013 an investor placed $10 000 into an account for 5
For example, suppose in 2013 an investor placed $10,000 into an account for 5
years with a fixed annual interest rate of 1% and another $10,000 into a stock
mutual fund. The rate of return in the stock fund will be uneven over the next few
years so a comparison between the two investments would be difficult.

Assume that at the end of the five-year period, the savings account’s balance is
$10,510.10 and, although the other investment has grown unevenly, the ending
balance in the stock fund was $15,348.52. Using CAGR to compare the two
investments can help an investor understand the difference in returns:

( $10,510.10 )
5
Savings Account CAGR = $10,000 − 1 = 1.00%

And:

( $15,348.52 )
5
Stock fund CAGR = $10,000 − 1 = 8.95%

On the surface, the stock fund may look like a better investment with nearly nine
times the return of the savings account. On the other hand, one of the drawbacks
to CAGR is that by smoothing the returns, CAGR cannot tell an investor how
volatile or risky the stock fund was.

Track Performance
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
 p p g p , y
period, Big-Sale Stores’ market share CAGR was 1.82%, but its customer
satisfaction CAGR over the same period was -0.58%. In this way, comparing the
CAGRs of measures within a company reveals strengths and weaknesses.

Detect Weaknesses and Strengths

Comparing CAGRs of business activities across similar companies will help
evaluate competitive weaknesses and strengths. For example, Big-Sale’s
customer satisfaction CAGR might not seem so low when compared with
SuperFast Cable’s customer satisfaction CAGR of -6.31% during the same period.

Investor Use of CAGR

Understanding the formula used to calculate CAGR is an introduction to many
other ways investors evaluate past returns or estimate future profits. The formula
can be manipulated algebraically into a formula to find the present value or
future value of money, or to calculate a hurdle rate of return.

For example, imagine that an investor knows that they need $50,000 for a child’s
college education in 18 years and they have $15,000 to invest today. How much
does the average rate of return need to be in order to reach that objective? The
CAGR calculation can be used to find the answer to this question as follows:

( $50,000 )
18
Required Return = $15,000 − 1 = 6.90%

This version of the CAGR formula is just a rearranged present value and future
value equation. For example, if an investor knew that they needed $50,000 and
they felt it was reasonable to expect an 8% annual return on their investment
they felt it was reasonable to expect an 8% annual return on their investment,
they could use this formula to find out how much they needed to invest to meet
their goal.

Modifying the CAGR Formula

An investment is rarely made on the first day of the year and then sold on the last
day of the year. Imagine an investor who wants to evaluate the CAGR of a $10,000
investment that was entered on June 1st, 2013 and sold for $16,897.14 on
September 9th, 2018.

Before the CAGR calculation can be performed, the investor will need to know the
fractional remainder of the holding period. They held the position for 213 days in
2013, a full year in 2014, 2015, 2016, and 2017, and 251 days in 2018. This
investment was held for 5.271 years, which calculated by the following:

2013 = 213 days

2014 = 365
2015 = 365
2016 = 365
2017 = 365
2018 = 251

The total number of days the investment was held was 1,924 days. To calculate
the number of years, divide the total number of days by 365 (1,924/365), which
equals 5.271 years.

The total number of years the investment was held can be placed in the
denominator of the exponent inside CAGR’s formula as follows:
denominator of the exponent inside CAGR s formula as follows:

( $16,897.14 )
5.271
Investment CAGR = $10,000 − 1 = 10.46%

Smooth Rate of Growth Limitation

The most important limitation of CAGR is that because it calculates a smoothed
rate of growth over a period, it ignores volatility and implies that the growth
during that time was steady. Returns on investments are uneven over time,
except bonds that are held to maturity, deposits, and similar investments.

Also, CAGR does not account for when an investor adds funds to a portfolio or
withdraws funds from the portfolio over the period being measured.

For example, if an investor had a portfolio for five years and injected funds into
the portfolio during the five year period, the CAGR would be inflated. The CAGR
would calculate the rate of return based on the beginning and ending balances
over the five years, and essentially count the deposited funds as part of the
annual growth rate, which would be inaccurate.

Other CAGR Limitations

Beside the smoothed rate of growth, CAGR has other limitations. A second
limitation when assessing investments is that, no matter how steady the growth
of a company or investment has been in the past, investors cannot assume the
rate will remain the same in the future. The shorter the time frame used in the
analysis, the less likely it will be for realized CAGR to meet expected CAGR when
relying on historical results.
A third limitation of CAGR is a limitation of representation. Say that an investment
fund was worth $100,000 in 2012, $71,000 in 2013, $44,000 in 2014, $81,000 in
2015 and $126,000 in 2016. If the fund managers represented in 2017 that their
CAGR was a whopping 42.01% over the past three years, they would be
technically correct. They would, however, be omitting some very important
information about the fund’s history, including the fact that the fund’s CAGR over
the past five years was a modest 4.73%.

CAGR vs. IRR

The CAGR measures the return on an investment over a certain period of time.
The internal rate of return (IRR) also measures investment performance but is
more flexible than CAGR.

The most important distinction is that CAGR is straightforward enough that it can
be calculated by hand. In contrast, more complicated investments and projects,
or those that have many different cash inflows and outflows, are best evaluated
using IRR. To back into the IRR rate, a financial calculator, Excel, or portfolio
accounting system is ideal.

Example of How to Use CAGR

Let’s say an investor bought 100 shares of Amazon.com (AMZN) stock in
December 2015 at $650 per share, for a total investment of $65,000. After 3 years,
in December 2018, the stock has risen to $1,750 per share, and the investor’s
investment is now worth $175,000. [1] What is the compound annual growth rate?

Using the CAGR formula, we know that we need the:

$
 Ending Balance: $175,000
Beginning Balance: $65,000
Number of Years: 3

So to calculate the CAGR for this simple example we'd enter that data into the
formula as follows:

( $175,000 )
3
CAGR for Amazon = $65,000 − 1 = 39.12%

This tells us that the compound annual growth rate for the investment in Amazon
is 39.12%.

Frequently Asked Questions

What is a compound annual growth rate (CAGR)?
CAGR is a measurement used by investors to calculate the rate at which a
quantity grew over time. The word “compound” denotes the fact that CAGR takes
into account the effects of compounding, or reinvestment over time. For example,
suppose you have a company whose revenue grew from $3 million to $30 million
over a span of 10 years. In that scenario, the CAGR would be approximately
25.89%.

What is considered a good CAGR?

What counts as a good CAGR will depend on the context. But generally speaking,
investors will evaluate this by thinking about their opportunity cost as well as the
riskiness of the investment. For example, if a company grew by 25% in an
industry whose average CAGR is closer to 30%, then their results might seem
 dust y ose a e age C G s close to 30%, t e t e esults g t see
lackluster by comparison. But if the industry-wide growth rates were lower, such
as 10% or 15%, then their CAGR might be very impressive.

What is the difference between a CAGR and a growth rate?

The main difference between a CAGR and a growth rate is that CAGR assumes the
growth rate was repeated, or “compounded” each year, whereas a traditional
growth rate does not. Many investors prefer CAGR because it smoothes out the
volatile nature of year-by-year growth rates. For instance, even a highly profitable
and successful company will likely have several years of poor performance during
its life. These bad years could have a large effect on individual years’ growth rates,
but they would have a relatively small impact on the company’s CAGR.

ARTICLE SOURCES

Related Terms
Annualized Total Return
Annualized total return gives the yearly return of a fund calculated to demonstrate the rate of return necessary to achieve a cumulative return.
more

Growth Rates
Growth rates are the percentage change of a variable within a specific time. Discover how to calculate growth rates for GDP, companies, and
investments. more

Compound Interest
Compound interest is the interest on a loan or deposit calculated based on both the initial principal and and the accumulated interest from