What is Internal Rate Of Return (IRR)
The IRR strategy is a method for determining whether or not to pursue a project or investment. The IRR rule argues that if a project’s or investment’s internal rate of return (IRR) is higher than the minimum needed rate of return, which is often the cost of capital, the project or investment should be pursued. If the IRR on a project or investment is less than the cost of capital, rejecting it may be the best course of action.
The IRR calculation in the excel sheet has one major flaw: it expects that the time gap between any two successive cash flows must be the same. This is a significant constraint because the time intervals between cash flows are not the same throughout the investment’s lifetime.
What is Compound Annual Growth Rate (CAGR)
The idea of compound annual growth rate (CAGR) is quite simple, requiring only three major inputs: an investment’s beginning value, ending value, and time period. Because it reflects the premise that the investment is multiplied over time, CAGR is preferable to average returns.
Advantages of Compound Annual Growth Rate (CAGR)
- CAGR is a good formula for evaluating different investment’s performance over time.
- Investors & Analyzers can compare the CAGR of various investments in order to know how well one stock/mutual fund has performed against other against-market index.
- The CAGR can be used to compare the historical returns of stocks to bonds or a savings account.
Disadvantages of Compound Annual Growth Rate (CAGR)
- It ignores volatility by assuming steady growth rate over the who duration of investment tenure, only taking into account an first and a final value
- It shows previous performance of the fund and hence you should not expect your investments to grow as per CAGR in future due to various volatile and unseen factors.
- It does not consider the intermediate values and relies only on the ending value and the beginning value which may again give a wrong picture of the investment if you ignore yearly returns.
CAGR is a method of smoothing out returns by determining an annual growth rate on an investment whose value has changed over time. In that respect, the compound annual growth rate (CAGR) isn’t the actual return in actuality. This is comparable to saying you went on a vacation and averaged 60 kilometers per hour. You did not travel at 60 kilometers per hour the entire time. You were going slower at times and faster at others.
CAGR V/S IRR
IRR and CAGR will be same when
- You make a lump sum investment and calculate returns for the same.
- You make multiple investments but the annual return is constant across years. These investments can be periodic like a SIP or recurring FD.
IRR and CAGR will be different when
- You make multiple investments and the annual returns are non-different. This will be the case with any volatile investment such as equities.
You should not use CAGR when you want to estimate returns for your mutual fund investments.
What is Extended Internal Rate of Return (XIRR)
The XIRR method is used to compute investment returns when numerous transactions occur at various times. When your cash flows (investments or redemptions) are spread over a period of time, this function is useful for calculating returns.
If you’re investing in mutual funds by SIP or lumpsum and redeeming via SWP or lumpsum, XIRR can handle both scenarios and assist you to generate a consolidated return based on the timings of your investments withdrawals.
You can think of XIRR as nothing but an aggregation of multiple CAGRs. If you make multiple investments in a fund, you can use the XIRR formula to calculate your overall CAGR for all those investments taken together.
Practically speaking, XIRR is essentially an extension of IRR that allows you to attribute precise dates to individual cash flows, making it a considerably more accurate method of calculating returns. All you have to do to calculate the XIRR in mutual funds is enter the transactions (SIP / SWP installments, additional purchases, redemptions, and so on) and the associated dates. You can collect these transaction details from the fund house’s statement of account and utilize the XIRR formula in an excel sheet.
|Description||A measure of growth at a compound rate||Average rate earned by every cash flow invested during a specified time period|
|Multiple Cash flows||No consideration of multiple cash flows||Considers multiple cash flows|
|Timing of cash flow||Only the time duration between initial & final cash flow matters||The returns are affected by the timings of multiple cash flows|
|Measurement||To measure the performance of lumpsum investment||Measurement of performance of multiple cash flows|
We hope this articles helps you understand the Difference between IRR, XIRR & CAGR. If you need any assistance on Investments, Insurance or How To Invest In Mutual Funds Feel free to contact Wealth Baba. We will try to help you out in the best possible way.