Compound Growth Rate: Definition & Calculation | [Your Brand]

The compound growth rate is a measure used specifically in business and investing contexts, that indicates the growth rate over multiple time periods. It is a measure of the constant growth of a data series. The biggest advantage of the compound growth rate is that the metric takes into consideration the compounding effect. Thus, it is especially significant in the assessment of returns from investmentsReturn on Investment (ROI)Return on Investment (ROI) is a performance measure used to evaluate the returns of an investment or compare efficiency of different investments..

Unlike average growth rates that are prone to volatility levels, compound growth rates are not affected by volatilityVolatilityVolatility is a measure of the rate of fluctuations in the price of a security over time. It indicates the level of risk associated with the price changes of a security. Investors and traders calculate the volatility of a security to assess past variations in the prices. Therefore, they are more relevant in the comparison of different data series.

Understanding the Compound Annual Growth Rate (CAGR)

The compound annual growth rate (CAGR) is one of the most frequently used metrics in financial analysis and financial modeling. In financial models, the CAGR is calculated for important operational metrics such as EBITDAEBITDAEBITDA or Earnings Before Interest, Tax, Depreciation, Amortization is a company's profits before any of these net deductions are made. EBITDA focuses on the operating decisions of a business because it looks at the business’ profitability from core operations before the impact of capital structure. Formula, examples, and also for capital expenditures (capex) and revenueRevenueRevenue is the value of all sales of goods and services recognized by a company in a period. Revenue (also referred to as Sales or Income). Also, the CAGR can be used for the forecasting of future growth rates.

However, one should be careful in using the compound growth rate in financial analysis. The metric smooths the historical data, omits the effect of volatility, and implies the steady growth of the data series. Due to those reasons, the compound growth rate should best be used together with some other metrics, and the context of the given situation must always be considered.

How to Calculate the Compound Growth Rate?

The formula for calculating the compound growth rate is:

Where:

• V_n – the ending value
• V₀ – the beginning value
• n – the number of periods

Example

Five years ago, Sam invested $10,000 in the stocks of ABC Corp. Below, you can see the total value of his investment at the end of each year:

• Year 1: $10,500
• Year 2: $8,500
• Year 3: $9,750
• Year 4: $10,700
• Year 5: 11,500

Sam wants to determine the steady growth rate of his investment. In such a case, the steady growth rate is equal to the compound annual growth rate (CAGR). The CAGR of his investment is calculated in the following way:

Over the five-year period, Sam’s investment grew by 2.8%. Please note that we used $10,000 as the beginning value because it was the amount of the initial investment.

Additional Resources

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• CAGR CalculatorCAGR CalculatorThis CAGR calculator will help you determine the Compound Annual Growth rate of an investment. CAGR is a great measure of growth, as it isolated the effect of compounding on growth, which is sometimes concealed on other metrics for growth. CAGR stands for compound annual growth rate.
• Capital ExpendituresCapital ExpendituresCapital expenditures refer to funds that are used by a company for the purchase, improvement, or maintenance of long-term assets to improve
• VIXVIXThe Chicago Board Options Exchange (CBOE) created the VIX (CBOE Volatility Index) to measure the 30-day expected volatility of the US stock market, sometimes called the "fear index". The VIX is based on the prices of options on the S&P 500 Index
• Year over Year (YOY)YoY (Year over Year)YoY stands for Year over Year and is a type of financial analysis used for comparing time series data. It is useful for measuring growth and detecting trends.