CAGR vs. IRR: An Overview
The compound annual growth rate (CAGR) measures the return on an investment over a certain period of time. The internal rate of return (IRR) also measures investment performance. While CAGR is easier to calculate, IRR can cope with more complicated situations.
The most important distinction between CAGR and IRR 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, a financial calculator, Excel, or portfolio accounting system is ideal.
Key Takeaways
- The most important distinction between CAGR and IRR is that CAGR is straightforward enough that it can be calculated by hand.
- The concept of CAGR is relatively straightforward and requires only three primary inputs: an investment’s beginning value, ending value, and the time period.
- IRR considers multiple cash flows and periods—reflecting the fact that cash inflows and outflows often constantly occur when it comes to investments.
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 CAGR calculators, will spit out the CAGR when entering these three values. An example of a CAGR calculation follows.
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%.
The CAGR is superior to an average returns figure because it takes into account how an investment is compounded over time. However, it is limited in 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.
The CAGR helps frame an investment's return over a certain period of time. It has its benefits, but there are definite limitations that investors need to be aware of.
In situations with multiple cash flows, the IRR approach is usually considered to be better than CAGR.
IRR
IRR is uniform for investments of varying types and, as such, IRR can be used to rank multiple prospective projects on a relatively even basis. The IRR is also a rate of return (RoR) metric, but it is more flexible than CAGR. While CAGR simply uses the beginning and ending value, IRR considers multiple cash flows and periods—reflecting the fact that cash inflows and outflows often constantly 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:
Example Investment | |
---|---|
Time period |
Cash Flow |
0 |
-1,000 |
1 |
400 |
2 |
500 |
3 |
600 |
4 |
700 |
In the above case, using the Excel function “IRR,” the rate is 36.4%.
The IRR is classified as a discount rate that utilizes net present value (NPV), making all cash flows equal to zero in a discounted cash flow (DCF) analysis. In most situations, the higher the IRR, the better the investment option. IRR is often used by companies when they must choose which project is best between many options. A project that has an IRR above its cost of capital is one that will be profitable.
Special Considerations
In reality, investments experience volatility. There is never a continuously smooth market cycle that experiences linear growth. When running a business or when expecting any sort of cash inflow, it is important for a business or investor to understand this so that they can successfully manage their cash.
For example, if a company makes an investment that provides $5,000 a month, which covers their debt payments and working capital, using CAGR they may expect that every month for the life of the project or investment they will receive a continuous cash stream of $5,000. However, some months may result in market or business volatility, where the investment return will be less than $5,000, or even be zero. This would impact their ability to make debt payments or fund working capital.
It is therefore more conservative and accurate to use IRR when seriously evaluating any investment options, as it will take into consideration true market volatility and the realities of the financial world.