Editorials

The most important word in value investing may be "compound." Charlie Munger has spent decades reminding us that stock market returns come from compounding over time, and that identifying businesses capable of steady, consistent growth is the fundamental task of the value investor. Yet many investors stumble when trying to measure that consistency. They look at last year's earnings or revenue, or they cherry-pick a spectacular five-year period and assume it will repeat forever. That's when CAGR—compound annual growth rate—becomes essential. It's the lens through which a value investor can see whether a business has actually compounded steadily or simply gotten lucky one year.

CAGR answers a straightforward question: if you had invested in a company at a fixed starting value and held it for a period of years, what would be your annualized return? The formula is equally straightforward:

CAGR = (Ending Value / Beginning Value)^(1/Number of Years) – 1

The key to understanding CAGR is that last part: the exponent 1/Number of Years. This is where the compounding magic happens. If you're measuring growth over five years, the exponent becomes 1/5, or 0.2. If you're looking at ten years, it's 1/10, or 0.1. This fractional exponent is what forces the average to account for the fact that money (or revenue) compounds—each year's growth builds on the previous year's.

Costco Wholesale provides an excellent real-world example. The warehouse giant reported fiscal-year revenues of $166.8 billion in 2020 and $275.2 billion in fiscal 2025. That's impressive in absolute terms, but what does it mean when annualized?

Using the CAGR formula:

• Ending Value: $275.2 billion (FY 2025)
• Beginning Value: $166.8 billion (FY 2020)
• Number of Years: 5
• CAGR = ($275.2 / $166.8)^(1/5) – 1 = (1.6504)^(0.2) – 1 = 0.1104, or 11.04%

Costco's revenue compounded at roughly 11% annually over that five-year window. That's meaningful—far better than inflation or nominal GDP growth—but it's also very different from what a casual observer might calculate by simply dividing 65% total growth by five years to get 13%. CAGR accounts for the mathematical reality that each year's revenue grows from the previous year's total, not from the original base.

Consider a hypothetical business that grew 50% in Year One, then -20% in Year Two. A simple average would suggest 15% annual growth. CAGR tells the truth:

• Simple average: (50% + (-20%)) / 2 = 15%
• CAGR: (1.5 × 0.8)^(1/2) – 1 = (1.2)^(0.5) – 1 ≈ 9.5%

The difference matters because volatility in growth is a red flag for value investors. A business that surges and falls is less predictable than one that climbs steadily. A simple average would miss that risk entirely, but CAGR captures it implicitly. Because CAGR forces the math to compound forward year by year, it will always be lower than a simple average when growth is uneven.

For Costco, the real test is whether that 11% revenue CAGR reflects steady, predictable growth or a business that happened to recover well from a temporary shock. That's where the next step—the sanity check—becomes critical.

Here is where many investors (and many marketing departments pitching mutual funds) go astray. You can manipulate a CAGR dramatically by choosing your start year carefully.

Consider measuring Costco's revenue from FY 2022 ($227 billion) to FY 2025 ($275 billion). Over three years, that's a CAGR of roughly 7.3%. Now measure from FY 2023 ($242 billion) to FY 2025: roughly 6.6%. But go back to FY 2020, and you get 11%.

None of these are lies. All are mathematically correct. But they tell very different stories about whether Costco's business is accelerating or decelerating. A fund manager pitching the three-year figure might be doing so because the business was recovering from COVID disruption in 2020-2021. By starting in 2022, they avoid including that rebound.

This is not academic. Choosing a favorable start year is one of the most common ways that investors convince themselves to buy overvalued businesses or miss warning signs in deteriorating ones.

The cure for arbitrary timing is simple: calculate CAGR across multiple time periods.

For Costco's revenue:

• 5-year CAGR (FY 2020–2025): ~11.0%
• 3-year CAGR (FY 2023–2025): ~6.6%
• 2-year CAGR (FY 2024–2025): ~4.0%

What does this pattern reveal? Costco's growth appears to be slowing. The five-year number is inflated by the strong recovery from pandemic lows in 2020. More recent figures suggest revenue growth is moderating—from double digits to single digits. That's not a disaster (Costco is still growing faster than the overall economy), but it's crucial information. A value investor who saw only the five-year CAGR without checking shorter periods might miss the deceleration entirely.

Better yet, this pattern suggests the company is maturing, which aligns with what we know: Costco is already a $275 billion revenue business operating in a fairly saturated U.S. market. Steady, mid-single-digit growth may be all that's realistic going forward. That's a very different investment thesis than a business still in hypergrowth.

Of course, revenue is only half the story. What matters to a shareholder is earnings—and whether management has maintained profitability while growing the top line.

Costco's net income grew from approximately $4.0 billion in FY 2020 to $8.1 billion in FY 2025. That's a CAGR of roughly 15.2%—faster than revenue growth. Why? Because Costco has leveraged its scale to improve margins and operational efficiency. That's the hallmark of a genuine compounder: growing revenue steadily while improving the bottom line even faster.

But again, the value investor should check shorter periods. Recent quarterly earnings show that growth is also moderating on the net income side, consistent with the revenue slowdown. The business is still generating strong returns, but the growth trajectory is cooling.

CAGR is a tool, not an answer. Its proper use requires discipline:

1. Always calculate multiple time periods. Five-year, three-year, and one-year CAGRs together tell you whether growth is accelerating or slowing. If the five-year CAGR is much higher than the recent one-year rate, the business may be losing momentum.

2. Compare to competitors and industry benchmarks. Is Costco's 11% revenue CAGR impressive? It depends. If the wholesale club industry is growing at 3% and Costco is growing at 11%, that's excellent relative performance. If competitors are growing at 15%, it's concerning.

3. Tie CAGR to the economic moat. A business with a strong competitive advantage should compound revenue at a higher rate than a commodity business. If Costco's revenue is growing only as fast as the overall retail sector, you might question whether its famed customer loyalty is actually providing a durable edge.

4. Watch the quality of earnings. Revenue CAGR is almost meaningless if it's achieved through accounting tricks or unsustainable margin expansion. Earnings CAGR matters more, and free cash flow CAGR matters most of all, because cash cannot be fudged.

5. Beware the backward-looking trap. CAGR measures what has compounded. It says nothing about what will compound. A 20-year CAGR is useful context, but a mature business that has compounded at 12% for two decades is not guaranteed to maintain that rate going forward. Competitive dynamics change. Markets saturate. That's why value investors focus on durable moats, not extrapolated CAGRs.

CAGR is simply a way to convert lumpy, year-to-year growth into a single annualized figure that tells you whether a business has actually compounded its value steadily. It's not magic, and it's not predictive. But it is far more honest than a simple average or a single-year figure.

For Costco, the data shows a business that has grown revenue at roughly 11% over five years, with that rate slowing to mid-single digits more recently. Earnings growth has been stronger, suggesting pricing power and operational leverage. Over multiple decades, Costco has demonstrated genuine compounding, which is rare.

But that historical CAGR tells us nothing about whether to buy the stock today or what returns it will generate tomorrow. For that, you need to understand the business, its moat, its competitive position, and its valuation relative to those fundamentals. CAGR is a tool for understanding the past so you can think clearly about the future. Used carelessly, it becomes a way to rationalize overpaying for past performance.