Compound Annual Growth Rate (CAGR)

• The Bottom Line: CAGR is the single, smoothed-out growth rate that shows you how an investment has performed annually over a specific period, cutting through the noise of market volatility.
• Key Takeaways:
• What it is: The effective year-over-year growth rate required for an investment to grow from its beginning value to its ending value, assuming the profits were reinvested each year.
• Why it matters: It provides a standardized and far more accurate picture of long-term performance than a simple average, which is crucial for understanding the power of compounding.
• How to use it: To compare the historical performance of different businesses, evaluate management's track record in growing earnings, and form a reasonable baseline for future growth assumptions.

Imagine you're on a five-hour road trip. For the first hour, you're stuck in city traffic, crawling at 15 mph. On the second and third hours, you hit the open highway and cruise at 75 mph. The fourth hour sees you in a construction zone at 30 mph, and the final hour is a mix of country roads at 50 mph. If someone asks, “What was your average speed?”, you wouldn't just add up 15, 75, 30, and 50 and divide by four. That would be meaningless. Instead, you'd figure out the total distance you traveled and divide it by the total time (five hours). The result would be a single, constant speed you would have needed to travel at for the entire five hours to cover the same distance. Maybe it's 52 mph. That 52 mph is your trip's “CAGR.” Compound Annual Growth Rate (CAGR) is the exact same concept, but for your money. An investment rarely grows at a steady pace. It might be up 20% one year, down 10% the next, and up 15% the year after. Looking at these numbers individually can feel like that chaotic road trip—it's hard to get a sense of the overall journey. CAGR solves this. It calculates the one, single, hypothetical growth rate that, if it had occurred steadily every single year, would have taken your investment from its starting value to its ending value over that period. It's the “average speed” of your capital's growth, and it's a powerful tool for seeing the big picture.

“Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it.” - Often attributed to Albert Einstein.

This quote gets to the heart of why CAGR is so important. It is the mathematical language of compounding, the engine that drives all successful long-term investing.

For a value investor, CAGR isn't just a metric; it's a mindset. We are not short-term traders trying to catch fleeting price swings. We are business owners who think in terms of years and decades. CAGR is a tool built for precisely this long-term perspective. First, it helps us see through the noise of mr_market's mood swings. The market can be manic-depressive, loving a company one year and despising it the next, causing wild fluctuations in stock price. A value investor, however, is focused on the underlying business. By calculating the CAGR of a company's fundamental metrics—like revenue, earnings, or free_cash_flow—over five, ten, or even twenty years, we can get a much clearer picture of the business's actual, long-term operational performance, ignoring the market's temporary drama. Second, CAGR is a report card on management's ability to create value. A management team's primary job is to allocate capital effectively to grow the company's intrinsic_value. A long history of a double-digit CAGR in earnings per share or free cash flow per share is powerful evidence of a competent and shareholder-friendly management team. Conversely, a flat or declining CAGR is a significant red flag, suggesting the business may lack a durable competitive_moat or that its leadership is failing. Third, it provides a sane baseline for future projections. A core task for a value investor is to estimate a company's future earning power to determine its intrinsic value today. While past performance is no guarantee of future results, a company's historical CAGR provides a crucial, data-driven starting point for our analysis. A business that has consistently grown its earnings at 8% per year for a decade is far more likely to continue that trajectory than a business with a volatile and unpredictable history. This historical context is essential for building a conservative forecast and ensuring a sufficient margin_of_safety. In short, CAGR helps a value investor focus on the long-term reality of a business, not the short-term fiction of the stock market.

The formula for CAGR might look intimidating at first, but it's quite simple once you break it down. CAGR = ( (Ending Value / Beginning Value) ^ (1 / Number of Years) ) - 1 Let's unpack that:

• Ending Value (EV): The value of the investment at the end of the period.
• Beginning Value (BV): The value of the investment at the start of the period.
• Number of Years (n): The total number of years in the measurement period.
• ^: This is the symbol for “to the power of.”

Essentially, you divide the end value by the beginning value, raise that result to the power of one divided by the number of years, and then subtract one. The result is expressed as a percentage.

The number you get is the smoothed-out annual growth rate. But what does it mean in practice? A value investor doesn't just look at one CAGR in isolation. We use it comparatively to uncover deeper truths about a business. The most powerful insights come from comparing the CAGR of different metrics over the same period. Consider this:

At first glance, Company A looks like a superstar with its 25% revenue growth. But a value investor sees the warning sign immediately. Its earnings are growing much, much slower than its revenue. This means its profit margins are shrinking. It's spending huge amounts of money to “buy” revenue, but that revenue isn't translating into actual profit for the owners. Company B, on the other hand, is a model of efficiency. Its earnings are growing faster than its revenue, which means its profit margins are expanding. Management is becoming more effective at turning sales into bottom-line profit. This is the hallmark of a high-quality business with a strong competitive moat. The Golden Rule of Interpretation: CAGR is a rearview mirror, not a crystal ball. It tells you with great clarity where a company has been, which is an invaluable guide. But it provides no guarantee of where it is going. A value investor uses historical CAGR as a critical piece of evidence in their analysis, not as a substitute for it.

Let's analyze two fictional companies to see CAGR in action. We want to invest for the long term and are looking at their earnings per share (EPS) performance over the last five years.

As you can see, both companies started with an EPS of $2.00 and ended with an EPS of $3.22. A casual observer might say their performance was identical. But let's look closer. Flashy Tech's journey was a rollercoaster. It experienced huge growth spurts and terrifying crashes. It's an unpredictable and volatile business. Steady Brew, in contrast, chugged along, growing its earnings by a predictable 10% each and every year. Now, let's calculate the 5-year CAGR for both.

• Beginning Value (BV): $2.00
• Ending Value (EV): $3.22
• Number of Years (n): 5

CAGR = ( ($3.22 / $2.00) ^ (1 / 5) ) - 1 CAGR = ( 1.61 ^ 0.2 ) - 1 CAGR = 1.10 - 1 CAGR = 0.10 or 10% The 5-year EPS CAGR for both companies is exactly 10%. The math tells us that, on average, they grew at the same rate. But the value investing insight is this: which business would you rather own? The one that produces predictable, consistent results year after year, or the one that gives you sleepless nights? The answer is clear. CAGR is powerful because it allows us to put these two very different journeys onto the same scale (10%). But our job as investors is to look beyond the final number and analyze the quality and consistency of that growth. Steady Brew Coffee Co. demonstrates the kind of durable, understandable business that a value investor treasures.

• Smooths Volatility: Its greatest strength is its ability to iron out the year-to-year bumps, providing a clear view of the long-term trend.
• Standardizes Comparison: CAGR allows for a true apples-to-apples comparison of the performance of different investments or companies over the same period.
• Highlights Compounding: It is the most direct way to measure the historical effect of compounding, which is the foundation of long-term wealth creation.
• Simple Concept: While the formula has a few steps, the core idea of a “smoothed average growth rate” is intuitive and easy to grasp.

• It is Purely Historical: This is the most critical limitation. CAGR tells you absolutely nothing about the future. A company's high historical CAGR could be due to a product that is about to become obsolete.
• Endpoint Sensitivity: The result can be dramatically manipulated based on the start and end dates you choose. If you calculate a stock market index's CAGR starting from the bottom of a crash (like March 2009), the result will look phenomenal. If you start from the peak of a bubble (like late 1999), it will look terrible. Always use a long, reasonable timeframe (5+ years) to avoid this distortion.
• It Ignores the Journey (Risk): As our example showed, two investments can have the same CAGR but wildly different levels of volatility and risk. CAGR measures the destination, but it tells you nothing about the turbulence on the flight to get there. A value investor always prefers a smoother, more predictable journey.
• It Assumes Reinvestment: The formula inherently assumes that all dividends and distributions are reinvested back into the investment. This might not reflect an investor's actual cash-in-pocket return if they spend their dividends.

• compounding
• intrinsic_value
• margin_of_safety
• Earnings Per Share (EPS)
• free_cash_flow
• long_term_investing
• circle_of_competence