Compound annual growth rate measures how an investment grows over a specific number of years. Investors looking at your small business examine the compound annual growth rate (CAGR) as a way to gauge past returns on investment in order to predict how their investments may pay off in the future.
What Are Examples of a Compound Annual Growth Rate?
The CAGR takes into account a variety of investments over a number of years. For example, your business can track how a bank loan saw its return on investment through five years. You can perform the same calculation on venture capital to compare it to the return on investment found in the bank loan. Internally, you can use CAGR figures to see how your own reinvestment of profits paid dividends to your income over several years.
What Is the Formula to Determine a CAGR?
The formula for CAGR is:
CAGR = ((Ending value / starting value) ^ (1 / (end time – beginning time))) – 1.
For example, say you started with an investment of $10,000 on Jan. 1, 2019. By Jan. 1, 2020, that investment grew to $12,000. On Jan. 1, 2021, the investment became $15,000. The investment went from $10,000 to $15,000 over two years.
The CAGR comes to (($15,000 / $10,000) ^ (1 / (2-1))) – 1. Doing the math, the CAGR is 22.47%.
The key to the formula lies in compounding. If the return on investment is 2% per year, the 2% works for the initial $10,000 investment. Then, the interest calculation works on $12,000 instead of $10,000. The CAGR formula takes into account an investment that grows or shrinks over several years.
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