Compound Annual Growth Rate
Meaning of Compound Annual Growth Rate
The compound annual growth rate (CAGR) of a company refers to the growth rate of an investment, year after year, for a particular time period. As explained by the Investopedia, the compound annual growth rate is, actually, not the real return. It is, rather an unreal number describing the rate at which an investment could have grown at a steady rate. The compound annual growth rate can, therefore, be explained as a method of smoothing out the returns.
Although not an accounting term, the concept of compound annual growth rate is used widely in growth industries in addition to being used for comparing the growth rates of two investments. This is for the reason that CAGR reduces the volatility effect of sporadic returns that can make arithmetic means extraneous.
The basic formula used for calculating the compound annual growth rate is:
V(t0) indicates the start value, V(tn) indicates the finish value, tn – t0 refers to the number of years.
As long as the real or standardized values retain the same mathematical proportions, they can be used for calculation.
The compound annual growth rate can also be calculated as the geometric mean of 1 added to each year’s return, minus 1.
Applications of compound annual growth rate
There are, however, certain CAGR applications. Some of these are listed below for your reference:
- Indicating and contrasting the investment advisors’ performance.
- Calculating and communicating the average returns produced by the average returns of investment funds.
- The CAGR is helpful in comparing the past returns of stocks with a savings account or even bonds.
- The CAGR aids a company in forecasting future values based on the CAGR of a data series.
- The compound annual growth rate is also useful in analyzing and communing the performance of distinctive business measures like sales, costs, market share, customer satisfaction, and performance, over a specified period of time.
The significance of CAGR lies in aiding a company to give a more abstract thought about its return on investment. Moreover, it smoothens out the returns year after year.