What Does Compound Annual Growth Rate (CAGR) Mean?
Compound Annual Growth Rate (CAGR) is the interest rate at which a particular investment grows over a period of time. It can also be described as the interest rate that allows an investment at current present value to turn into a future amount within a specified time frame. It is calculated as follows:
CAGR = [(FV / PV) ^ 1/n] - 1
Whereas, FV is future value or the ending value of an investment; PV is the present value or the beginning value of an investment; and n is the number of years.
Divestopedia Explains Compound Annual Growth Rate (CAGR)
CAGR is used to measure the value of an investment and its growth over a given period of time to estimate the total return on a particular investment. While the annual rate of return gives the amount of return every year, CAGR gives the return over the entire period of the investment. As a result, investors are better able to evaluate the returns on different investments before making a choice on which works best for them.
Though some people prefer to use the arithmetic average of the growth rate over the period of investment, it is not accurate and CAGR should be used instead. For example, a company's revenue rose from $5 million in the first year to $7.5 million in the second year, but fell back to $5 million in the third year. When arithmetic average is used, the revenue rose by 50 percent the second year and fell by 33 percent the next year. As a result, the arithmetical mean is 8.5% ((50 - 33) / 2 )). However, in reality, the revenue has not increased by any amount after the three years. The method of calculating CAGR produces more accurate results because it is based on geometric averaging.
Calculating CAGR is an important analysis in determining the value of a business. In a comparable company analysis, CAGR will assist in selecting the universe of comparable companies with similar growth rates. In a discounted cash flow analysis, the CAGR of the target company will help determine appropriate future growth rates to use in projecting cash flows.