Due Diligence

Compound annual growth rate (CAGR) represents the annualised rate at which an investment, business metric, or portfolio grows over a specified period, assuming that gains are reinvested each year and growth occurs at a steady, compounded pace. CAGR serves as a critical metric for both investors and business strategists due to its ability to smooth volatile performance into a single, comparable growth rate for analysis and forecasting.

Definition and Calculation
CAGR quantifies how much an investment or financial metric (such as revenue, EBITDA, or asset value) would have grown if it had developed at a constant compounded rate between a defined starting and ending value over a certain period (usually greater than one year).

The compound annual growth rate (CAGR) equation is:

The compound annual growth rate (CAGR) represents the annualised rate at which an investment, business metric, or portfolio grows over a specified period, assuming that gains are reinvested each year and growth occurs at a steady, compounded pace. CAGR serves as a critical metric for both investors and business strategists due to its ability to smooth volatile performance into a single, comparable growth rate for analysis and forecasting.

where:

• – Ending Value = value at the end of the period
• – Beginning Value = value at the start of the period
• – n = number of years (or periods)

Applications and Significance
CAGR is especially valued for its role in:

• Evaluating historical investment performance while minimising the distortion from year-on-year volatility.
• Comparing the relative performance of different investment opportunities or business units by standardising growth rates.
• Informing forward-looking projections by providing a baseline growth assumption that incorporates the effects of compounding.

CAGR does not reflect actual annual returns; instead, it depicts a hypothetical steady rate, offering clarity when reviewing performance over inconsistent periods or for benchmarking against industry standards. It is widely used in strategy consulting, financial modelling, budgeting, and decision analysis.

Leading Strategy Theorist: Alfred Rappaport
Alfred Rappaport is closely associated with financial performance metrics and their application in corporate strategy, making him a central figure in the context of CAGR’s strategic use. Rappaport is an Emeritus Professor at the Kellogg School of Management, Northwestern University, renowned for pioneering the concept of shareholder value analysis—a framework that hinges on the rigorous evaluation of cash flows and the long-term compounding rate of return (paralleling the logic of CAGR).

Rappaport’s seminal book, Creating Shareholder Value, published in 1986 (and subsequently updated), positioned value creation as the primary objective of management, with CAGR-based metrics being critical to tracking value growth through discounted cash flow analysis. His work profoundly shaped the discipline of value-based management, which relies on compounding growth rates both in forecasting and in performance assessment.

Throughout his career, Rappaport has acted as both an academic and adviser, influencing leading corporates and institutional investors by promoting disciplined investment criteria and strategic decision-making grounded in robust, compounding growth metrics like CAGR. His recognition of the importance of compound returns as opposed to simple arithmetic averages underpins the widespread adoption of CAGR in professional practice.