Welcome to the CAGR Party- Measuring Growth

There are many financial calculations utilized to analyze performance and observe trends. While in a perfect world, all businesses would experience nothing but constant and exponential growth – in the real world there are ebbs and flows as a result of the economy, demand for products/services, innovation and new product launch, among many others. The Compound Annual Growth Rate, or CAGR, calculation is utilized to provide a “smoothed average” of performance.

Take the following financial overview as an example. Company ABC experienced growth from Year 1 to Year 2, followed by two consecutive years of declining revenue and profits, with a happy ending at the end of Year 5 – significant growth beyond Year 1 levels.

cagr-1

.

.

Growth (or loss) as a percentage is expressed below:

cagr2

.

.

The problem with this average (as is with most straight averages) is that it overstates performance. So what do we do…enter CAGR. Your CAGR would be the ratio of your ending value to beginning value (Year 5 / Year 1) raised to the power of 1/4 (since 1/# of years = 1/4), then subtracting 1 from the resulting number.

(Side Note: A major misconception might be the misinterpretation of periods versus years. Within our dataset, there are 5 periods observed; however, the time that lapses between Year 1 and Year 5 is 4 years. As an example, if we observed two financial statements for the fiscal years ending December, 31, 2013 and December 31, 2014, this would represent the financials for two years, but a time lapse of only 1 year as the time between the two year ending dates – December 31 of 2013 to December 31 of the next year – is only 1 year.)

Utilizing the CAGR calculation, we are now presented with a different picture:

cagr3

The above CAGR observation will be a better indicator of utilizing appropriate growth metrics to be utilized in numerous approaches for valuing the subject company. It is only a small piece of the puzzle, but an important formula that is critical to clearly understand and implement in the formation of applicable growth and discount rates.

.

.

X