Compound annual growth rate
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Compound Annual Growth Rate (CAGR) or cumulative annual growth rate is another term for the 'rate of return' or 'interest rate' variable in the formula Present value of a dollar and Future value of a dollar discussed at time value of money. It measures the rate of change in a value between two points in time(t and t0). These equations are basic to the concept of compound interest.
In business, CAGR is used to describe the growth over a period of time of some element of the business, usually revenue, although other measures may be used (such as the number of units delivered, registered users, etc.). CAGR is not an accounting term, but remains widely used, particularly in growth industries. CAGR is preferable to applying more simplistic terms, such as "business doubled in three years", as it properly accounts for the effect of compounding.
[edit] Example
A company may double its sales over a period of four years. Applying the formula above, the CAGR is approximately 18.9% (not 25% per year).
Don't worry if this concept is still fuzzy to you - CAGR is one of those terms best defined by example. Suppose you invested $10,000 in a portfolio on Jan 1, 2005. Let's say by Jan 1, 2006, your portfolio had grown to $13,000, then $14,000 by 2007, and finally ended up at $19,500 by 2008.
Your CAGR would be the ratio of your ending value to beginning value ($19,500 / $10,000 = 1.95) raised to the power of 1/3 (since 1/# of years = 1/3), then subtracting 1 from the resulting number:
1.95 raised to 1/3 power = 1.2493. (This could be written as 1.95^0.3333). 1.2493 - 1 = 0.2493 Another way of writing 0.2493 is 24.93%.
Thus, your CAGR for your three-year investment is equal to 24.93%, representing the smoothed annualized gain you earned over your investment time horizon.
