Compound Annual Growth Rate (CAGR)

What is the Conceptual Meaning of CAGR?

The compound annual growth rate (CAGR) is a practical metric to facilitate sound decision-making, but it is critical to understand that the CAGR as a standalone metric still does not reveal the entire story.

To truly grasp the conceptual meaning of CAGR, it is necessary to comprehend the benefits, as well as the metric’s limitations.

Benefits of CAGR

• Removal of Fluctuations → Since annualized growth metrics remove the fluctuations of year-over-year (YoY) growth rates, the single percent rate facilitates comparisons of CAGR over time between two companies or investments, which would otherwise be challenging to compare.
• “Sanity Check” → Since the CAGR metric can confirm whether the projections align with the industry average and historical growth, the CAGR metric can also be useful as a “sanity check”, i.e. to confirm the assumptions are reasonable.
• Convenience → The relative ease at which the CAGR can be computed is a notable benefit to using the metric, while still providing valuable insights into the growth profile of anything that rises (or falls) in value.

Limitations of CAGR

• Volatility Risk → One drawback to the CAGR is that the metric neglects the volatility associated with the underlying asset. The growth rate can therefore be misleading in the absence of year-over-year (YoY) data. For instance, a company’s revenue growth could be inflated if the positive growth is front-ended in the earlier periods before tapering off.
• Operating Drivers → Annualized metrics such as the CAGR should not be taken at face value to minimize the risk of understating (or overstating) the growth potential without understanding the underlying operating drivers.
• Historical Performance (≠) Future Performance → Per usual, “past performance is no guarantee of future results”. Therefore, relying on the historical CAGR to build a pro forma forecast requires a certain degree of caution. The historical CAGR (or industry averages) should serve as a precedent to reference, as part of a more in-depth analysis of the company (or investment).

What is a Good CAGR?

Simply put, the percentage growth rate that constitutes a “good” CAGR is contingent on the company-specific fundamentals, the industry (or sector) benchmark established by comparable companies, and various other external factors.

• Mature (Late-Lifecycle) → Mature companies operating in long-standing industries (>10 years) with limited growth opportunities could have a projected five-year CAGR of around 3% to 5%, which could perhaps be perceived positively by investors in the market.
• Late-Stage (Growth Equity) → In contrast, growth-stage companies could view a CAGR of around 10% to 20% as the norm. Here, a company that expects revenue to grow at a CAGR of 3% to 5% is trailing behind the industry benchmark.
• Early-Stage (Venture-Backed) → Finally, early-stage companies such as startups could target a CAGR in excess of 50% (or even 100%), which are ambitious growth targets often required to raise enough funding from venture investors (VC).

Suppose a company’s revenue is projected to grow at a CAGR of 20%, but the company’s closest comparables are expected to grow around 5%, while the collective industry is forecast to grow 3% across the same periods.

The company’s growth assumptions would likely warrant adjustments of some sort, or at least a closer look into whether the projected figures are reasonable or not (“sanity check”).

If the assumptions are deemed reasonable, the company is likely to receive much attention (and capital) from investors, as its growth profile is an outlier within the industry, i.e. well-positioned to continue to grow at an outsized pace and become the market leader with the highest market share over the long-term.

Conversely, if the industry CAGR is projected to be 40% in the same time horizon – instead of 5% like our previous scenario – the company’s estimated growth is far behind its peers.

CAGR Calculator

We’ll now move on to a modeling exercise, which you can access by filling out the form below.

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1. Revenue Growth Assumptions

Suppose we are tasked with calculating the compound annual growth rate (CAGR) of a company’s revenue.

At the end of the current period, the company has generated $100 million in revenue – and this figure is expected to grow at the following growth rates each year.

• Year 0 → Year 1 = 10.0%
• Year 1 → Year 2 = 8.5%
• Year 2 → Year 3 = 8.0%
• Year 3 → Year 4 = 6.5%
• Year 4 → Year 5 = 5.0%

By the end of Year 5, the company’s revenue reaches $144 million, after starting at $100 million in Year 0.

• Revenue – Year 0 = $100 million
• Revenue – Year 1 = $110 million
• Revenue – Year 2 = $119 million
• Revenue – Year 3 = $129 million
• Revenue – Year 4 = $137 million
• Revenue – Year 5 = $144 million

2. CAGR Calculation Example

Like the previous example, we will input the following assumptions into the CAGR formula:

• Beginning Value = $100 million
• Ending Value = $144 million
• Number of Periods= 5 Years

Our CAGR formula divides $144 million (i.e. the future value) by $100 million (i.e. the present value) and then raises it to 1 divided by 5 (i.e. the number of periods).

In the subsequent step, we subtract the resulting figure by one to arrive at 7.6% as the implied 5-year CAGR.

• CAGR (%) = ($144 million ÷ $100 million)^(1 ÷ 5 Periods) – 1 = 7.6%

3. CAGR Calculation in Excel

An alternative method to determine the historical or expected CAGR is to utilize the “RATE” function in Excel.

The COUNTA function can count the number of years (nper) for the first input, and we can hard-code a zero for the next input (pmt).

In the next steps, we can enter -$100 million for the present value (pv), and $144 million for the future value (fv), with a negative sign placed in front of either 1) the present value or 2) the future value.

For our illustrative example, the CAGR formula in Excel would be as follows.

4. CAGR Revenue Forecast Example

Contrary to a common misconception, the calculation of CAGR is not as simple as averaging the YoY growth rates.

But rather, given the initial value, ending value, and specific date parameters, the CAGR metric assumes the profits are reinvested each period and that interest is compounded annually.

To ensure you understand the concept of CAGR, we have also computed the implied revenue to illustrate how CAGR can be used to forecast a company’s revenue, or “sanity check” the assumptions that underpin a projection model.

In the section beneath the initial part of our quick modeling exercise in Excel – where we had computed the 5-year CAGR – we’ll start by linking to the cell containing the $100 million assumption for Year 0 (Cell D5).

From that point onward, we will project our company’s revenue across the five-year forecast period, using the constant CAGR of 7.6% as the growth rate assumption in each period.

• Implied Revenue, Year 1 = $100 million × (1 + 7.6%) = $108 million
• Implied Revenue, Year 2 = $108 million × (1 + 7.6%) = $116 million
• Implied Revenue, Year 3 = $116 million × (1 + 7.6%) = $125 million
• Implied Revenue, Year 4 = $125 million × (1 + 7.6%) = $134 million
• Implied Revenue, Year 5 = $134 million × (1 + 7.6%) = $144 million

By growing the revenue of our hypothetical company by the 5-year CAGR of 7.6% each year, the company’s forecasted revenue reaches $144 million by the end of Year 5, confirming that our prior calculation of CAGR is, in fact, correct.