In dealing with any form of investment (e.g., stocks), compound annual growth rate (CAGR) is a convenient tool to compute the rate at which something (e.g., revenue) increases over a given time period. This takes into consideration the impact of compounding on an annual basis. The main idea in compounding is that interest earned from the principal is added to it for the next calculation. The new total will again gain interest over time.

It often takes a period of five years before a trend is determined. Then a company’s growth is gauged and compared with the industry in general and with the competitors at large.

CAGR Formula

CAGR = AB – 1 wherein: A = (Final Value / Initial Value); B = (1 / number of years)

Example

In order to understand the concept, an example must be given. Consider this situation: You buy

$5,000 worth of stock. After a year, its value becomes $4,000, or 20% decline. In two years, it amounts to $6,000, or 50% increase.

If you wanted to boast to your friends, you might say that you have gained a 50% increase in your stock last year. Someone who has known you for some time would much more likely be concerned about finding your overall return, in percent, since you purchased the stock.

The solution is as follows: A = 6,000 / 5,000 = 1.2

B = 1 / 2 = 0.5

Thus, CAGR = 1.20.5 – 1 = 0.0955, or approximately 9.55%. To double check, use the original value and work forward.

· Original stock bought at $5,000

· 9.55% increase = $5,000 x 1.0955% = $5,477.5

· 9.55% increase = $5,477.5 x 1.0955% = $6,000.6

When you use simple computation, however, you might arrive at a different answer, as shown below:

· You have $6,000 now.

· You originally have $5,000.

· By subtracting the two, you will get $1,000, or 20% growth, for two years.

· You gained 10% profit per year.

To avoid the above mistake, you should therefore carefully follow the CAGR formula.

Other Applications

This principle needs to be grasped carefully because it can be applied as long as an investment is concerned, as in the following:

· To compute and broadcast the mean returns of investments

· To show and compare the action of investment consultants

· To know the history of stock returns, bonds, or savings accounts

· To predict the movement of sales, costs, market share, and others over a time period