In our last update, we introduced the Compound Annual Growth Rate (CAGR) for some of the stocks in our portfolio. Moving forward, we plan to replace our manual growth calculations entirely with CAGR, using company-specific growth metrics. After extensive analysis, we’ve determined that CAGR provides a more accurate reflection of a stock’s performance, offering deeper insights into its long-term valuation.
This shift is aimed at enhancing our intrinsic value calculations and refining our decision-making process when it comes to evaluating stocks. Unlike traditional methods that rely on simplified linear growth projections, CAGR smooths out the annual growth rate of an investment over a period of time, making it a far more reliable indicator of sustainable growth.
What is CAGR?
CAGR stands for Compound Annual Growth Rate. It measures the mean annual growth rate of an investment over a specified period of time, assuming the investment grows at the same rate every year. Unlike a simple average, CAGR takes into account the compounding effect, making it a more realistic reflection of long-term growth.
How is CAGR Calculated?
The formula for CAGR is straightforward:
[ \text{CAGR} = \left( \frac{\text{Ending Value}}{\text{Beginning Value}} \right)^{\frac{1}{n}} - 1 ]
Where:
- Ending Value is the final value of the investment after the specified period.
- Beginning Value is the initial value at the start of the period.
- n is the number of years over which the investment grows.
Example of CAGR Calculation:
Let’s say you’re evaluating a stock that had a price of $50 three years ago and has grown to $75 today. The CAGR would be calculated as:
[ \text{CAGR} = \left( \frac{75}{50} \right)^{\frac{1}{3}} - 1 = 0.1447 \text{ or } 14.47\% ]
This means that the stock has grown at an average rate of 14.47% annually over the past three years.
Why We’re Moving to CAGR for Stock Valuation
CAGR offers several advantages over traditional growth methods, especially in the context of intrinsic stock valuation:
- More Accurate Reflection of Growth: CAGR smooths out year-to-year volatility, providing a clearer picture of long-term performance. This is especially important for stocks in sectors that experience cyclical or fluctuating growth.
- Eliminates Outliers: By considering the start and end points of the investment period, CAGR helps neutralize the effects of outliers (i.e., extraordinary growth in one year or a significant drop in another), which can skew the valuation when using simple growth rates.
- Better Alignment with Market Expectations: Many analysts and institutional investors use CAGR in their own valuation models. By aligning with this standard, we provide consistency and comparability, which can enhance the accuracy of our stock analyses.
As we transition to this new methodology, we believe it will give us more consistent, data-driven insights that will help guide investment decisions and improve portfolio performance. The shift to using CAGR for intrinsic value calculations also aligns with our commitment to providing you with the most reliable and forward-looking analysis possible.