Using the compound annual growth rate means that a company has the ability to measure any balance sheet items or income statement items year to year or can simply find an average over an extended period of time. By doing this the CAGR equation allows a company to remove the volatility from year to year and find a nice smooth average over a time period. It should be noted that the CAGR comes in use during larger time periods or periods without drastic outliers in the growth.
The Compound Annual Growth Rate formula is as follows:
Jerry is attempting to make some pro forma statements for his company. He decides that he wants to grow the predictions out for five years. He believes that the same amount of historical information is needed as well. Jerry also decides that he would like to grow all of his predictions by the sales growth rate. He finds that in Year 1 the growth rate was 5% and in Year 5 the growth rate was 8%. Jerry will calculate the CAGR as follows:
CAGR = (.08/.05)(1/5) – 1 = 9.86%