The Compound Annual Growth Rate (CAGR) describes the average annual growth of a metric such as revenue, market size, user base, or investment over several years. It assumes that profits are reinvested and compounded each year, resulting in a steady growth rate over the entire period.
Also known as the Annualized Growth Rate or Geometric Average Growth Rate, the CAGR provides a simple way to show how a metric has developed over time without being distorted by short-term fluctuations.
The CAGR (Compound Annual Growth Rate) shows how much a value grows on average per year. You can think of it as a steady annual return where profits grow with compound interest each year.
To calculate the CAGR, you only need three values: the starting value, the ending value, and the number of years.
The formula summarizes the total growth over the period and converts it into an average annual growth rate, as if the value had increased evenly every year.
Here is the formula:
Example:
If an investment grows from 100 to 150 over 3 years, the CAGR is:
1. First divide the final value by the initial value:
2. Since the period covers three years, you now take the cube root:
3. To turn this into a percentage, subtract 1:
This means the investment grew as if it had increased by about 14.5 % every year on a compounded basis.
Even though the CAGR is usually not reported directly in financial statements, it is an important tool in financial analysis, strategy development, and investment decisions.
Its main advantage is that it summarizes multi-year developments into a single, comparable growth rate. This makes it easier to assess long-term performance without short-term fluctuations distorting the picture.
The key applications of the Compound Annual Growth Rate include:
These applications matter because CAGR helps transform complex data into a clear and comparable measure. Whether you are evaluating a company, assessing a market, or building a valuation model. CAGR provides a straightforward way to capture growth over time and apply it to business decisions.
While CAGR is a helpful tool for summarizing growth over time, it comes with important limitations. A common misconception is that a high CAGR means steady year-on-year performance. In reality, CAGR tells you nothing about how smooth or volatile the growth path was. Two companies may have identical CAGR figures but completely different levels of risk or consistency.
Another key limitation is that CAGR only looks at the beginning and end values. It ignores any cash flows that happen in between. For example, if you receive dividends, reinvest capital, or make additional contributions during the period, CAGR will not reflect their effect. In such cases, other metrics like the Internal Rate of Return (IRR) give a more accurate picture because they account for the timing of each cash flow.
CAGR also assumes that growth is compounded at a constant rate, which often doesn't match real business dynamics. If you're projecting volatile markets or irregular investments, relying only on CAGR may lead to oversimplified or misleading conclusions.
In interviews, being able to explain these limitations shows that you understand not just how to use a metric, but also when to challenge it.
Here are common interview questions about CAGR with short, clear answers to help you feel confident in interviews.
The revenue grew at a CAGR of about 12.5% over 5 years. That shows strong long-term growth and provides a clear summary of the revenue trend. To put the number into context, it can be compared with the growth rates of other business units or industry peers.
CAGR can be misleading when growth is volatile, because it smooths out fluctuations and only reflects the start and end values. It also ignores interim cash flows, such as dividends or additional contributions, and can be distorted by one-off events at the end of the period. In such cases, other measures like year-by-year growth rates or IRR provide a more accurate picture.
CAGR is often used to make simple growth projections. For example, in a DCF model, past CAGR can be taken as a starting point to estimate how revenue or cash flow might develop in the future. It gives a quick and clear way to build assumptions before adjusting them with more detailed analysis.
CAGR, or Compound Annual Growth Rate, captures the average yearly growth of a value over a multi-year period, assuming gains are compounded annually. It offers a simple and consistent way to summarize long-term performance in a single rate, making it especially useful for interpreting revenue development, market trends, or investment returns. Its ability to smooth out fluctuations makes it a go-to metric in finance, consulting, and strategic analysis.
In valuation contexts, CAGR is frequently used to project future growth in models such as DCF or comparables. Interviewers often expect candidates to apply CAGR when estimating future values, comparing performance across business units, or extrapolating market size. However, it’s important to understand that CAGR has limitations. It ignores volatility, interim cash flows, and assumes a steady growth path, which often doesn’t reflect reality.
