A:

The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. The internal rate of return, or IRR, also measures investment performance but is more flexible than CAGR.

CAGR

The concept of CAGR is relatively straightforward and requires only three primary inputs: an investment’s beginning value, ending value, and the time period. Online tools, including Investopedia’s CAGR calculator, will spit out the CAGR when entering these three values. The CAGR is superior to average returns because it considers the assumption that an investment is compounded over time. One limitation is that it assumes a smoothed return over the time period measured, only taking into account an initial and a final value when, in reality, an investment usually experiences short-term ups and downs. CAGR is also subject to manipulation as the variable for the time period is input by the person calculating it and is not part of the calculation itself. Consider the following investment:

Initial Value = 1,000

Final Value = 2,200

Time period (n) = 4

[(Final Value) / (Initial Value)] ^ (1/n) - 1

In the above case, the CAGR is 21.7%

IRR

IRR is also a rate of return but is more flexible in that it considers multiple cash flows and periods. While CAGR simply uses the beginning and ending value, in reality cash inflows and outflows occur when it comes to investments. IRR can also be used in corporate finance when a project requires cash outflows upfront but then results in cash inflows as an investment pays off. Consider the following investment:

Time period

Cash Flow

0

-1000

1

400

2

500

3

600

4

700

In the above case, using the Excel function “IRR,” we obtain 36.4%.

Differences Between CAGR and IRR

The most important distinction is that CAGR is straightforward enough that it can be calculated by hand. In contrast, more complicated investments and projects, or those that have many different cash inflows and outflows, are best evaluated using IRR. To back into the IRR rate, a financial calculator, Excel, or portfolio accounting system is ideal. The example above used Excel to calculate the IRR but computation on a financial calculator is similar.

The Bottom Line

The CAGR helps frame an investments return over a certain period of time. It has its benefits, but there are definite limitations that investors need to be aware of. With multiple cash flows, the IRR approach is usually considered to be better than CAGR.

RELATED FAQS
  1. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The concept of CAGR is relatively straightforward and requires only three primary inputs: an investments beginning value, ... Read Answer >>
  2. Why is the compound annual growth rate (CAGR) misleading when assessing long-term ...

    The compound annual growth rate (CAGR) measures the return on an investment over a certain period of time. Below is an overview ... Read Answer >>
  3. How do you calculate CAGR?

    Find out how to understand and use the compound annual growth rate formula, and find out why it helps put an uneven performance ... Read Answer >>
  4. What is the formula for calculating internal rate of return (IRR) in Excel?

    Understand how to calculate the internal rate of return (IRR) using Excel and how this metric is used to determine anticipated ... Read Answer >>
  5. What is the formula for calculating the internal rate of return (IRR)?

    Learn about the internal rate of return, an important concept in determining the relative attractiveness of different investments. Read Answer >>
  6. Which is a better measure for capital budgeting, IRR or NPV?

    In capital budgeting, there are a number of different approaches that can be used to evaluate any given project, and each ... Read Answer >>
Related Articles
  1. Trading

    Compound Annual Growth Rate: What You Should Know

    The CAGR is a good and valuable tool to evaluate investment options, but it does not tell the whole story.
  2. Markets

    The Most Accurate Way To Gauge Returns: The Compound Annual Growth Rate

    The compound annual growth rate, or CAGR for short, represents one of the most accurate ways to calculate and determine returns for individual assets, investment portfolios and anything that ...
  3. Investing

    Internal Rate Of Return: An Inside Look

    Use this method to choose which project or investment is right for you.
  4. Entrepreneurship & Small Business

    Calculating the Internal Rate of Return Using Excel

    The internal rate of return on investments is explained and illustrated in different investment scenarios.
  5. Investing

    Return on Investment (ROI) Vs. Internal Rate of Return (IRR)

    Read about the similarities and differences between an investment's internal rate of return (IRR) and its return on investment (ROI).
  6. Markets

    Internal Rate of Return Formula for Excel

    The internal rate of return, or IRR, is a popular metric businesses use to measure a project’s return on investment.
  7. Financial Advisor

    The 15 Fastest-Growing RIAs

    Registered investment advisors are consolidating their business and assets. Here are 15 of the fastest-growing RIAs.
  8. Managing Wealth

    Learn Simple And Compound Interest

    Interest is defined as the cost of borrowing money, and depending on how it is calculated, can be classified as simple interest or compound interest.
  9. Investing

    Capital Budgeting: Which is Better, IRR or NPV?

    Using internal rate of return and net present value for capital budgeting evaluations often end in the same result. But there are times when using NPV to discount cash flows makes more sense.
  10. Investing

    An Introduction To Capital Budgeting

    We look at three widely used valuation methods and figure out how companies justify spending.
RELATED TERMS
  1. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth ...
  2. Internal Rate Of Return - IRR

    A metric used in capital budgeting measuring the profitability ...
  3. IRR Rule

    A measure for evaluating whether to proceed with a project or ...
  4. The Net Internal Rate Of Return - Net IRR

    A measure of a portfolio or fund's performance that is equal ...
  5. IRR

    The currency abbreviation or currency symbol for the Iranian ...
  6. Pooled Internal Rate Of Return - PIRR

    A method of calculating the overall internal rate of return (IRR) ...
Hot Definitions
  1. Duration

    A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. ...
  2. Dove

    An economic policy advisor who promotes monetary policies that involve the maintenance of low interest rates, believing that ...
  3. Cyclical Stock

    An equity security whose price is affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies ...
  4. Front Running

    The unethical practice of a broker trading an equity based on information from the analyst department before his or her clients ...
  5. After-Hours Trading - AHT

    Trading after regular trading hours on the major exchanges. The increasing popularity of electronic communication networks ...
  6. Omnibus Account

    An account between two futures merchants (brokers). It involves the transaction of individual accounts which are combined ...
Trading Center