CAGR

1) The CAGR stands for the Compounded Annual Growth Rate.

2) It is the average annual growth rate for a particular investment over a period of time (usually more than a year).

For example: If a company reports a CAGR of 10% for 5 years, it means that when compounded on an annualized basis, the company has shown a consistent growth rate of 10% over all 3 complete years. It may have grown higher in one specific year while lower in another specific year, but on average, it has grown at 10%.

3) The formula for calculating CAGR is as follows

where N = time-period over which you are computing the growth rate.

For example: I buy a stock for $100 which has the following performance over 3 years. Year 1: $122 (Gain of 22%)

Year 2: $89 (Loss of 27%) Year 3: $105 (Gain of 18%) As you can see, the performance of the stock has been all over the place. If I calculate CAGR, I will get (105/100)^(1/3) – 1 which is equal to a gain of 1.6%. Hence, by computing CAGR, I have smoothed the annualized gain of the stock over the investment time horizon.

Hence, CAGR gives a broader performance metric for the investment versus a daily fluctuating and volatile performance analysis.

4) The fact that CAGR smoothens the returns over time is also a setback. A computation of CAGR over a time horizon may indicate steady growth, but delving deeper into the performance of each year, it could be possible that one year’s performance was largely negative.

5) This brings us to another issue of CAGR and that is the extent of representation. Depending on the value of “n: in the above equation, your value for CAGR will also change.

The following is data for Proofpoint (PFPT). Notice how the returns and the price changes differ based on what you decide to look at.

- Soham Mukherjee Editor in chief