Oftentimes, accountants and attorneys are reviewing a series of data points listed in time order. Examples include revenue per year, net income per year, annual expenses, and annual investment account values. In analyzing and reviewing the time series, the following question often emerges: Given the number of periods involved, what is the average annual growth rate in revenues, net income, expenses, etc?
In order to answer this question, you will need to perform a fairly straight forward calculation called the Compound Annual Growth Rate or CAGR. The following calculation may look like an eye exam at first glance, but a quick example will demonstrate how easy it is to employ in real world examples.
Let’s assume that you are looking at the annual dividends on the S & P 500 from 2000 to 2017. You observe that the value of dividends in 2000 is $16.27. In 2017, the value is $49.73. The number of years (often denoted as “n” in textbooks and in academic examples) is eighteen. Using the above formula, we can proceed to calculate the CAGR in dividends from 2000 to 2017:
CAGR = (49.73 ÷ 16.27) ( 1 ÷ 18 ) – 1
CAGR = 6.40%
There are many CAGR tools online, and you can even perform this calculation in EXCEL. However, knowing the “HOW” behind CAGR will help you to truly appreciate why compounding is oftentimes called the “8th Wonder of The World”.
This guest post was written by Thomas McDevitt, CFA, CFP, EA. All opinions are his own. The above references an opinion and is for educational purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice prior to making investment decisions.