Please, help me to understand which metric is better to use when forecasting the income statement. Please, see two examples below. I do thank you in advance - it is so crucial for me to understand this, and I can’t figure out myself. Maybe someone has a real life practice in this?
Example based only on one item from the fin statements:
Revenue:
1643 1753 2056
Growth rate:
year1 = (1643-1499)/1499 = 0.09606
year2 = (1753-1643)/1643 = 0.0669
year3 = (2056-1753)/1753 = 0.1728
Geomean = 0.1110
CAGR = (2056/1643)^(1/3)-1 = 0.0776
So for projected revenue growth which rate should I use -geomean or CAGR?
Next SG&A:
145 190 202
Common size SG&A:
0.088 0.108 0.098
Geomean SG&A = ((1+0.088)*(1+0.108)*(1+0.098))^(1/3) - 1 = 0.09808 (computed in Excel, so it takes into account invisible trailing numbers)
or shoud I use the rate = (0.098 / 0.088)^(1/3) - 1?
Thank you very much for your reply. When you say more conservative, do you mean that it is because it gives a much lower result in most cases, and it’s better to use a lower growth rate projected into the future, then a higher one?
But what about historical rate? Which one is more close to reality given the historic data - geo mean or CAGR?
CAGR is a better testament of historical returns. Geo mean can have outliers such as a year of +14% or -20% that can skew your numbers. CAGR takes that into account and smoothens the numbers.
Geo mean is more useful for computing returns and CAGR is better suited for projections.
I was doing some light reading by Damadoran at NYU last night and saw him talking about geometric averages AS a compounded rate which I believe to be true. However, I agree that Geometric Means are more commonly utilized for calculating returns.
I didn’t look at the calculations but as indicated in my comment before, when one of the preeminent valuation experts in the world refers to geometric means being analogous to compounded rates, it is probably true! However, I do think that from a naming convention:
Multi period returns=Geometric means
Mutli year growth in something like revenues=CAGR
So yes, I think they are equivalent mathematically.
Here is the table from the article, and at the end you see CAGR, which is not computed as (final value / first value) ^ (1/number of years) - 1, but as a geo mean. CAGR (157 / 115) ^ (1 / 5) - 1 = 6.42%, but geo mean (1.15*1.2*0.95*1.2)^(1/5) - 1 = 9.49%, and geo mean, as mentioned by Iprofit4sure is a compound rate used to account for all fluctuations - it does take into account years of negative growth, as well as those with high growth.
Also referring to the last post post by Iprofit4sure, according to the example above it seems that CAGR and geo mean do not always produce the same result.
