The most important limitation of the CAGR is that because it calculates a smoothed rate of growth over a period, it ignores volatility and implies that the growth during that time was steady.
Disadvantage of CAGR: Smoothing and Risk
One disadvantage of the Compound Annual Growth Rate is that it assumes growth to be constant throughout the investment's time horizon. This smoothing mechanism may yield results that differ from the actual situation with a highly volatile investment.
Advantages and Disadvantages of CAGR
The CAGR is superior to other calculations, such as average returns, because it takes into account that values compound over time. On the downside, the CAGR dampens the perception of volatility.
Calculate the total number of years or periods over which the growth occurred. Use the formula: CAGR = (Ending Value / Starting Value) ^(1 / Number of Years) – 1. Multiply the result by 100 to express the CAGR as a percentage.
Higher risk and volatility: Growth stocks are often more volatile, with significant price swings due to high valuations or market sentiment. A small earnings miss can lead to sharp declines in stock price.
If you want to compare and evaluate the long-term performance of various investments on an equal footing, CAGR is more appropriate. If you want to know the actual gains or losses of an investment over a specific time period, Absolute Return is more straightforward and informative.
For irregular investments with detailed cash flow data, XIRR is often more useful and accurate than CAGR since it accounts for the timing and size of all cash inflows and outflows. However, for regular investments focused on long-term growth, CAGR may be sufficient and easier to calculate.
In financial models, the CAGR is calculated for important operational metrics such as EBITDA, and also for capital expenditures (capex) and revenue. Also, the CAGR can be used for the forecasting of future growth rates.
But negative CAGR can and does exist. If a portfolio or profits decline over time — if they show negative overall growth — then CAGR by definition will be negative. Quite obviously, negative CAGR is not a good thing, for the same reason that negative growth of any kind (with rare exceptions) is not a good thing.
For companies with large capitalization, a CAGR in sales of 5% to 12% is good. For small-cap and midcap companies, a CAGR of 15% to 30% is good. Startup companies, on the other hand, should have a CAGR ranging from 100% to 500%.
However, it's important to remember that CAGR is not a guarantee of future performance. Market conditions can change, and there's always inherent risk in any investment. Additionally, CAGR is more reliable for longer investment periods.
What is CAGR? CAGR, or Compound Annual Growth Rate, measures the rate of return of an investment over a certain period, in percentage terms. In other words, CAGR is the imaginary growth rate at which an investment is expected to grow steadily on an annually compounded basis. CAGR is also known as an annualised return.
Usually, anything under an 8% CAGR is poor, but a good rate really does depend on the specific organisation. For example, companies who have been around for 10 or more years may see a CAGR of 8%-12% which is a good rate of sales for the amount of time they have been in business.
You may consider CAGR of around 5%-10% in sales revenue to be good for a company. CAGR is used to forecast the growth potential of a company. For a Company with a track record of over five years, you may consider a CAGR of 10%-20% to be good for sales.
Reverse CAGR measures future value of current investment over a specified period, accounting for compounding effects.
Both CAGR and absolute returns are considered valuable metrics when it comes to evaluating investment performance, but the key difference lies in their approach to time. Generally, CAGR is a preferred metric for longer-term investments.
It's easy to calculate the CAGR by the equation above, as long as you really are given only three inputs (present value, future value, and years). One example is the "average" inflation rate in the US, which is really the CAGR defined by applying the formula to the appropriate values of the Consumer Price Index (CPI).
CAGR is better than a simple average because it accounts for the compounding effect, providing a more accurate measure of growth over time. A simple average might ignore the compounding returns and fluctuations in the investment's performance, potentially leading to misleading conclusions about growth rates.
Diversification is the riskiest of the four growth options. This strategy involves introducing a new product into an entirely new market, where you may need more experience.
Drawbacks/Limitation of Growth Analysis:- In
classical growth analysis sampling for primary values consist of harvesting (destructively) representative sets of plants or plots and it is impossible to follow the same plants or plots throughout whole experiment.
Most angel investors are relatively wealthy individuals who are looking for a higher rate of return than can be found in more traditional investment opportunities. They search for startups with intriguing ideas and invest their own money to help develop them further.