Compound Annual Growth Rate (CAGR) – Definition, Calculation, Examples & Limitations
The Compound Annual Growth Rate (CAGR) is a really important tool for a consultant to compare long-term growth scenarios.
What Is a Compound Annual Growth Rate (CAGR)?
The Compound Annual Growth Rate (CAGR) is the average rate at which a value (e.g. business or investment) increases over a certain period of time.
Why Is the CAGR Important in Consulting?
Consultants often like to compare the current year growth rate with the following year growth rate (see Benchmarking). Looking at year over year growth rates is often subjected to several one-off influencing factors. Additionally, consultants often have to work with Growth Plans that include a company’s goals for the future (usually for the next 5 years).
These growth plans, in turn, consist of a set of measures each having different impacts in different years. A question asked very often is: how much does the company grow on average? In order to answer this question, you need to use the CAGR. The CAGR shows the yearly growth of an indicator if it had grown at a steady rate Y-o-Y.
CAGR in Case Interviews
More than likely, you will not be asked to calculate a CAGR in a Case Interview but knowing what it means and also knowing the formula will get you through the majority of the cases during interviews.
How to Calculate the CAGR: Formula
As an easy way to check your results during case prep, you can use the CAGR calculator.
Example and Calculation
Your interviewer gives the following graph on a client’s sales in the last 7 years and wants you to find their CAGR.
Sales in 2006 were 0.8 million Euros (beginning value). In 2013, after 7 years, sales increased to 1.8 million Euros.
This means, if the company grew each year from 2006 onwards with a rate of ~12% (12.28%), sales in 2013 would be 1.8 million Euros.
Applications and Additional Uses
- Calculate the average growth of a single investment
- Compare investments
- Track performance of various business measures or companies
- Detect competitive weaknesses and strengths
The Difference Between CAGR and IRR
Both the Internal Rate of Return (IRR) and the CAGR can measure investment performances. However, the IRR is more flexible and a lot more difficult to calculate. Whereas you can calculate the CAGR by hand, the IRR ideally needs a financial calculator, excel or a portfolio accounting system. The IRR is used for the evaluation of more complicated investments and projects with different cash inflows and outflows.
Limitations and Rules of Thumb
- The CAGR does not tell you anything about the real sales in the years between the starting year and the end year
- Theoretically, it is possible that all the growth happens only in the first or in the last year
- While this is somewhat part of what is wanted when using the CAGR (to make growths comparable) this is also a restriction: Two investments can have the exact same CAGR but one of them can be much more favorable since the growth is faster earlier on. The NPV (Net Present Value) is key to understand this concept.
- Dividing 72 by the CAGR will roughly give you the number of years to double the starting revenues (Rule of 72)
- CAGRs are most commonly used for periods of 3-7 years. For periods longer than 10 years, the CAGR is considered suitable only in special cases because at this point, it starts to mask sub-trends.
CAGR in Excel
You can calculate the CAGR by using the RRI function shown below:
- CAGR is a theoretical steady growth rate over a specific amount of time
- CAGR is not the average of the Y-o-Y growth rates
- It doesn’t reflect highs and lows and could mask sub-trends within the period
- You will probably encounter CAGR in graphs that the interviewer will hand out to you but you are not likely to have to calculate CAGR yourself