Compound Annual Growth Rate refers to the measurement which attempts to reduce the volatility of annual gains in growth during a set out number of years. The growth gains it considers include income, profits, customers, and more. The idea is to reduce the volatility over the years as if the growth had occurred evenly each year in the time frame under consideration. It can also be defined more technically as the average annual rate of growth for a given investment throughout a defined time period that exceeds a single year.
This means that the Compound Annual Growth Rate is not actually the real rate of return. Instead it is more like a representative figure. In other words, it is a fictitious percentage that spells out the investment return rate assuming that growth in said investment had been even and consistent over the years. In the real world, this almost never occurs. The reason to use such an artificial construct as this CAGR is to make the returns on a given investment more understandable.
Determining this Compound Annual Growth Rate is complex. It involves taking the investment value at the conclusion of the period under consideration. This must be divided by the value from the start of the period. The result has to be raised to a power of one divided by the total period length. This number that results must then be subtracted from the whole number one to get the final result for CAGR. It is a complicated formula that is difficult for most people to grasp if they are not mathematicians.
This is why looking at a tangible example makes it simpler to follow. Assume a certain corporation had three years of sales that were $300 million in the first year, $450 million in the second year, and $800 million in the third year. The growth rate was different every year. Its second year it increased by 50 percent while its third year the growth rate was almost 78 percent. Using the Compound Annual Growth Rate would smooth this out to provide a picture as if the company’s rate of growth per year had been steady over the three years considered. It is the compounding part that makes the formula so complex. This also explains why investors and analysts who figure this value will use a business calculator or a program that figures out the equation for them once they plug in the appropriate numbers of starting value, end value, and number of years.
Yet the Compound Annual Growth Rate is useful to businesses, investors, and analysts in particular. It helps investors who are interested in comparing and contrasting the rates of growth (over a predetermined amount of time) for two or more funds or firms. This would not be a simple task if they instead utilized the volatile and changing year over year growth rates.
Thanks to the simplicity of this measurement, it has utility in several other cases. In its simplest form, investors or analysts can employ the CAGR to figure out the average annual growth for one investment. As an example, investments might gain in relative value each year at the varying rates of plus seven percent the first year, minus one percent the second year, then plus six percent the third year. Using this CAGR will help the investor or analyst to get a bigger picture of the three year progress made by the investment in question.