What is Internal Rate of Return (IRR)? And How Does it Works?
What is the Internal Rate of Return (IRR)? And How Does it Works?
Hi readers. A lot has been covered in our blog since inception, we have written articles ranging from the basics of financial statements to concepts of valuation. A reader who has followed our blog from the beginning should now be able to perform a detailed analysis of a company and arrive at a valuation for investment.
To our ever growing list of posts, today we shall add one that seeks to provide a method for calculating the rate of return of a portfolio. This method is called as Internal Rate of Return (IRR).
The IRR method to measure the portfolio performance has become a lot popular in recent days because of its effectiveness over CAGR measurements. That’s why you need to get acquainted with what actually is IRR and how to quickly calculate it.
The topics we shall read about in today’s post are as follows.
- What is the Internal Rate of Return (IRR)?
- How is IRR different from CAGR and how is it more useful?
- Application of IRR method of return calculation with an example.
It’s going to be a very informative post. So, let’s get started.
1. What is the Internal Rate of Return (IRR)?
Theoretically speaking, IRR is the rate at which the net cash flows (both inflow as well as outflow) from an investment would be equal to zero. Better said, it is the rate of return to be achieved by all the money invested to give back all the cash received.
2. How is IRR different from CAGR and how is it more useful for investors?
Although CAGR is a classic investment metric for calculating investment returns and makes a better representation of performance than average returns since it assumes the investment capital to be compounded over time.
But it makes a couple of assumptions which may hinder its practical use. Firstly, it assumes that the compounding process is a smooth one over time with steady returns being made every year. Secondly, it assumes that a portfolio incurs cashflow only two times during its lifetime. One at the very beginning when an investment is made and the second when the investment is sold and cash is returned to the investor.
In practice rarely do we come across such scenarios where an investment is made only once, most of us happen to make regular investments over time and hence the overall return may actually be different than what the CAGR method of calculation may usually project it to be.
In such cases of multiple or uneven investment periods and cash flows, the CAGR method of calculation becomes futile and using the Internal Rate of Return method would better serve the purpose. Mathematically, the IRR calculation is represented by the following expression.
Where P0, P1, . . . Pn equals the cash flows in periods 1, 2, . . . n, respectively; And, IRR equals the investment’s internal rate of return.
3. Application of IRR method of return calculation with an example.
Assume we bought a stock ₹3,00,000. Also, assume that we bought an additional ₹1,00,000 worth of stock one year later and another ₹50,000 in the two years later.
Let us make one more assumption that we hold the stock for 2 more years before selling the stock for a total cash return of ₹7,50,000
Here is how the IRR equation looks in this scenario:
Mathematically speaking IRR cannot be computed analytically, but thanks to calculators and spreadsheets today this task can be done fairly easily.
Using the XIRR function in an excel we get the IRR for this scenario as 11.80%, which is the rate that makes the present value of the investment’s cash flows equal to zero.
If we were to calculate the CAGR for the example for an initial investment of ₹4,50,000 and final cash return of ₹7,50,000 over a period of 5 years we would get a but the incorrect return of 10.8%.
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Although initially, the IRR method found applications in the capital budgeting projects of companies, recently it has become a favored method among investors to calculate the capital allocation efficiency of their portfolio.
We advise our readers to add this to their ever-growing investing toolkit. Happy Investing.
Levin is a former investment banker and a hedge fund analyst. He is an NIT Warangal graduate with around 5 years experience in the share market.