The Compounded Annual Growth Rate (CAGR) is the annual growth rate over a period of time
The CAGR is a really important tool for a consultant to compare long-term growth scenarios
Consultants often like to compare current year growth rate with the following year growth rate (see benchmarking) and 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. An often asked question 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.
How do you calculate the CAGR?
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. 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.
Restrictions and rules of thumb of CAGR
- 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 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.