One of the most powerful metrics in all of finance is the internal rate of return (IRR). It’s also one of the most difficult to calculate which is why it can generate some confusion. If you can understand the basic drivers behind IRR, it can prove useful. Most of all, it can make you seem like you belong in the upper echelons of high finance.
Calculating the return on an investment can done with a number of different formulas. Sometimes it’s as simple as calculating your gain over the amount of the investment. Suppose you invested $100 today to buy a share of Company XYZ. A few years from now, you sell your shares for $120. Your simple return on investment would be 20 percent since you earned $20 above your initial investment. The problem with this method, however, is that it ignores the time value of money. This is where the internal rate of return can help.
The IRR looks at how much you earned on an investment. In other words, it’s the annualized effective compounded return rate. Suppose you invested $100 thousand in a project that produces five years of cash flows along with an assumed sale at the end of year five. If you were to discount each of these projected cash flows using the present value, you would see that your IRR is the “r” or discount rate that allows the sum of the present value annual cash flows to be equal to the $100 thousand initial investment. It’s the discount rate at which net present value (NPV) equals zero.
IRR is useful in evaluating multiple investment opportunities. An investor can compare the opportunities and focus on those with the highest IRRs. Calculating IRR manually can be nearly impossible but a good financial calculator or Excel spreadsheet can get the job done.
Reuben Advani is the author of The Wall Street MBA 3rd Edition (McGraw-Hill).