The CAGR, Compound Annual Growth Rate, is the average annual growth rate of an investment over a time horizon longer than one year. In a formula, this rate is found by calculating the ratio between the value of an investment at the end of the period and the initial value, all raised by one, over the number of years between the beginning and end of the investment. The result found is then subtracted by one. This is how the formula is written, with 'Vfinal' representing the final value, 'Vbegin' the initial value and 't' the reference period (i.e. the number of years).
The CAGR is a very flexible indicator used in various fields. From the world of finance to the corporate world. It becomes very useful when you want to calculate for a given time period, for example:
- The average return on an investment;
- The trend of a company's revenue stream;
- The growth in sales volume of a certain product;
- The growth of the value of one's personal assets;
- Etc. (the applications are manifold).
One should not confuse the CAGR with the annual rate of return of an investment, because it is rather an imaginary value, which explains how the investment would have grown on average over the number of years of its duration, if its growth had remained constant during that period (which hardly ever happens since growth is subject to periodic variations).
How to use CAGR to evaluate an investment
As a yardstick for evaluating an investment, the CAGR allows us to understand what the average growth rate is over a specific period of time, irrespective of what may be the potentially very marked annual variations that may affect one way or another in an individual period.
In essence, the CAGR, while not telling us how we arrived at the final result, gives us an overall idea of the performance of an investment over a given period. It is therefore very important to choose when to use this indicator, always bearing in mind that it is an average.
A number of considerations should therefore be made in this regard. First of all, the CAGR is not a 'true' number, in the sense that it is an extrapolated average, so if we are faced with any average growth of 5% in two years, using this indicator we will not know whether the second year the growth was 3% or 7% (or we may even have had a decline in one of the two years). The CAGR does not give us any details in this respect.
Another consideration concerning the use of this indicator tells us that, if we take into account a particularly 'slow' year and a bright year, the CAGR will show very high growth rates, but probably less credible on closer analysis.
A final consideration is that if the return on an investment has been at a certain value in the past, this is no guarantee that the same growth rate will be achieved in the future. The undoubted advantage of the CAGR is of course the fact that given the initial and final values, as well as the intervening periods, one can easily obtain the average annual return and thus a useful indication.
CAGR as an index for evaluating a start-up company
The CAGR can be very useful for start-ups, precisely because of its nature as a summary indicator. In fact, as mentioned above, it can be easily used to obtain an average of the growth rates, even very different, that a company has experienced over the years.
Start-ups in particular, given the great volatility of growth rates, can benefit from a single value that represents the trend over time in a simple and synthetic way.
Typical phenomena for start-ups are ups and downs in turnover, capital increases and general financial instability. The CAGR makes it possible to see things as a whole, setting a starting point and an end point, and establishing what the average growth rate is, so as not to be confused by figures that are either too illusory or falsely disappointing.