How to use CAGR in your business plan
Business plans often predict how much a target market might grow over time and the resulting changes to financial performance. One measure I’ve seen used more frequently in recent months is the CAGR – the Compound Annual Growth Rate. This percentage describes the mean average growth each year over a defined period. It’s often used to compare investment strategies, growth plans, and performance relative to markets and competitors.
Market research and analyst briefings sometimes use the CAGR to show how a market might change over 5 or 10 years. This gives valuable insight into what changes in business performance might be expected if nothing is done differently. For example, if the market is growing at a CAGR of 5%, and the business has historically grown at 5%, changing nothing could see the same market share 5 years from now.
In this post, I’ll explore what the CAGR is, how it can be used and why it’s not always the best number for planning.
How to calculate the CAGR
The formula is:
CAGR = ((EV/SV)^(1/n))-1
where EV is the end value, SV is the beginning value and n is the number of years.
This calculation divides the end value by the start value, raises the result by the power of 1 divided by the number of years, then subtracts 1 from this result. The final answer is a decimal number that represents the mean average percentage rate of growth over n years.
There isn’t a specific CAGR function in Excel, Sheets or Numbers. The XIRR function in Excel generates an Internal Rate of Return, which is subtly different from the CAGR.
Using CAGR to calculate a market size
Sometimes the start value and CAGR are known, but not the end value. This often happens when using market research sourced from press releases in planning. For example, suppose the market has a CAGR of 5% over the next 5 years, and the business grows at the same rate as the market. In this case, the future business size can be calculated using the following formula:
EV = SV * (1 + CAGR/100) ^ n
where SV is the starting value, CAGR is a percentage, and n is the number of years in the period.
This takes the starting revenue of the business and multiplies it by 1 plus the CAGR /100, with the result raised to the power of n. If the CAGR is already a decimal (e.g. 5% is entered as 0.05), dividing by 100 is unnecessary.
How CAGR can help in planning
The Compound Annual Growth Rate shows the mean average growth of an investment over a period of time. This makes it useful to compare and contrast different options during planning. It can also break down big targets into more manageable ones.
In an extreme example, say your market will double over the next 5 years from €1,000 to €2,000. You own a 10% market share, which means your current revenue of €100 has to double to €200. It sounds challenging but doable as you are standing still in market share terms. Intuitively it may sound as if you have to do very little.
But let’s say you want to double your market share to 20%. That means quadrupling your revenue to €400. Growing by 400% sounds far more challenging than standing still and may feel unachievable. What can you do that brings in four times the sales you’re getting today?
The good news is you don’t have to do that in one leap. Using the CAGR equation, 400% over 5 years becomes roughly 32% yearly. Each year in your five-year plan, you must increase your revenue by about a third on the previous year.
That’s because the growth is compounded. This year’s revenue grows by a third over last year’s. Next year, you must add a third of THIS year’s revenue to meet your target. That gives you a bigger number again, which edges closer to your goals.
As you plan, you can assess options against this CAGR target. The estimated returns from different courses of action can be looked at and timed accordingly. Investing in a program now to increase retention might look attractive, but if it’s fighting for budget against one to bring in 30% more customers in 12 months, you may want to hit the big win first and feed in the retention next year.
Calculating the CAGR is relatively easy, which makes it appealing for business planning when detailed analysis and models aren’t yet necessary.
However, it is a limited measure. Markets don’t grow in nice straight lines, which the CAGR implies. Seasonal variations, political upheavals, and even sporting events can all affect the actual rate of change. For that reason, while it’s a helpful headline figure for summaries and comparisons, detailed planning will likely require a more refined approach.
The CAGR also lacks context. Risk, dynamics and competition are embedded into the calculation without explanation. As such, it’s easy to look at a 5% CAGR and accept it as truth without understanding the assumptions behind it.
If you are using CAGR, make some assumptions about what happens in the middle. A straight line gives you a mean, which isn’t as helpful as you think:
- explore what happens to your model if the majority of growth occurs in the first half of the period, then do it again as if the second half is where the action happens
- look at what happens when unit costs and prices fall (the effect of increased competition in a growing market)
The Bottom Line: CAGR is a useful summary
CAGR has its place as a headline measure of the rate of change for a market over time. It’s a simplistic tool that lacks context and subtlety but is helpful to understanding whether objectives are reasonable and guide high-level business planning.