Knowing where your business is going, and how fast it’s heading there, is essential.
In the financial metrics category, Compound Annual Growth Rate (CAGR) stands-out as the king of macro metrics.
Read-on as we dive into what CAGR is, how you can use it, and how your CAGR compares to others.
Compound Annual Growth Rate (CAGR) is the measure of an investment’s or business’s annual growth rate over time. This period of time typically takes place over several years, during which CAGR accounts for compounding, or the reinvestment of profits at the end of each financial period. The result is a hypothetical growth rate that is normalized so that all changes occur evenly across each individual period.
In other words, it is the average rate of return that would need to occur each year in order for a business to grow from its beginning value to its ending value.
Because CAGR measures the cumulative performance of a business or product over a specified number of years, it is an important metric for determining viability and making investment decisions.
Note: An alternative method for calculating performance is Internal Rate of Return (IRR). While more complicated than CAGR, it is considered a more flexible metric since it can handle multiple cash flows, different investments, and investment periods.
Calculating CAGR is an easy process once you have all of your data in place. You will need the following data in order to calculate CAGR:
Starting date: The month and/or year where you are beginning your measurement.
Starting value: The value of the business at your starting date.
Ending date: The month and/or year where you are ending your measurement.
Ending value: The value of the business at your ending date.
Here is how to put these together into the formula:
(Ending value ÷ Starting value)^(1 ÷ N) - 1 = CAGR
So in order to get your CAGR, you’d first divide your ending value by your starting value. Then you’d raise the result to the inverse number of compounding periods (1/N). Finally, you’d subtract 1 in order to convert this figure into a percentage.
Let’s use an example to better visualize this.
Say your company’s Annual Recurring Revenue (ARR) is 1 million dollars at the start of 2018. Your goal, by 2022, is to reach an ARR of 3 million. This would give us the following data:
Starting value: 1 million
Ending value: 3 million
Compounding periods: 4
And here is how that would look in the formula:
(3M ÷ 1M)^(1 ÷ 4) - 1 = 31.6% per year
So in order for your company to grow its ARR from 1 million to 3 million in a time frame of four years (2018 to 2022), you would need to grow at an average rate of at least 31.6% each year.
CAGR is a macro tool used to measure and project movements over long periods of time:
By removing the year-to-year fluctuations that would otherwise make such predictions challenging, CAGR is often used to give a general direction at the market or country level.
At the country level, this is how the OECD compares different countries' GDP growth.
At the market level, this is how industry and market research reports project future growth.
By using this as a simple metric that ignores fluctuations, it makes it easy to compare different markets or different economies.
With a wealth of performance data already behind them, companies that have reached a mature stage of growth stand to make the best use of CAGR.
For instance, public companies all report on their CAGR and expected CAGR. This is a quick way for an investor to understand past performance and future potential when making an investment decision.
Although CAGR is useful in many ways, it’s also important to keep in mind its limitations.
One of CAGR’s key features – how it normalizes growth rate across multiple financial periods – can also be a potential limitation. By not taking into account the annual year-over-year volatility, CAGR can often not be a very useful metric when forecasting growth rate during unstable periods.
For example, let’s say you calculated a CAGR of 45% for the next five years. In the first year, your ARR was 70%. In year two, it was 50%. And in year three, it was 30%.
By just comparing this against your projected CAGR, you might come to the conclusion that you’re right on track (your average ARR so far is equal to your 45% CAGR). However, what this masks is that your year-over-year growth rate is on the decline. By not paying attention to this potentially dangerous sign, you may be misled into thinking your business is on better footing than it actually is.
The same reasons that make CAGR less effective of a metric in times of volatility also mean it is less useful for startups.
Companies in early growth stages are naturally volatile. It is common for profits to be low – or even for the company to incur large amounts of debt as it sinks revenue into product development, customer acquisition, and other longer-term needs.
As such, growth can be variable and highly unpredictable. During this time, CAGR will be less relevant than other metrics, such as Customer Acquisition Cost (CAC) and churn.
Determining a good CAGR will depend on many different factors, such as the type of company, the product or service offered, the category of customer being sold to, and even its geographic location. By isolating any of these factors, you could try comparing your CAGR to other similar companies. But this may be difficult unless you have access to their performance data. Instead, it may be more useful to use growth rate by ARR in order to benchmark your CAGR.
The chart above shows company ARR growth rates divided across different sizes. By looking at just the 75th percentile, we can narrow our focus to only the top 25% of companies that responded to the survey. The difference in their growth rates shows a clear trend: as ARR grows bigger, rate of growth tends to go down.
New companies (<1M) = 114% is a good benchmark
Early stage (1M < 20M) = 80% is a good benchmark
Scale-up (20M < 100M) = 60% is a good benchmark
Mature company (> 100M) = 30% is a good benchmark
Because this is looking at ARR rather than CAGR, this is purely be an informative exercise.
Ultimately, the best benchmark for measuring your CAGR will be your own. As you look at your past growth rates, you will want to see steady increases in line with your company maturity stage.