The compound growth rate is a measure used specifically in business and investing contexts, that indicates the growth rate over multiple time periods. It is a measure of the constant growth of a data series. The biggest advantage of the compound growth rate is that the metric takes into consideration the compounding effect. Thus, it is especially significant in the assessment of returns from investments.
Unlike average growth rates that are prone to volatility levels, compound growth rates are not affected by volatility. Therefore, they are more relevant in the comparison of different data series.
Understanding the Compound Annual Growth Rate (CAGR)
The compound annual growth rate (CAGR) is one of the most frequently used metrics in financial analysis and financial modeling. In financial models, the CAGR is calculated for important operational metrics such as EBITDA, and also for capital expenditures (capex) and revenue. Also, the CAGR can be used for the forecasting of future growth rates.
However, one should be careful in using the compound growth rate in financial analysis. The metric smooths the historical data, omits the effect of volatility, and implies the steady growth of the data series. Due to those reasons, the compound growth rate should best be used together with some other metrics, and the context of the given situation must always be considered.
How to Calculate the Compound Growth Rate?
The formula for calculating the compound growth rate is:
Vn – the ending value
V0 – the beginning value
n – the number of periods
Five years ago, Sam invested $10,000 in the stocks of ABC Corp. Below, you can see the total value of his investment at the end of each year:
Year 1: $10,500
Year 2: $8,500
Year 3: $9,750
Year 4: $10,700
Year 5: 11,500
Sam wants to determine the steady growth rate of his investment. In such a case, the steady growth rate is equal to the compound annual growth rate (CAGR). The CAGR of his investment is calculated in the following way:
Over the five-year period, Sam’s investment grew by 2.8%. Please note that we used $10,000 as the beginning value because it was the amount of the initial investment.
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