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. While CAGR is easier to calculate, IRR can cope with more complicated situations.
How to Calculate 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.
As an example, consider an investment in which the:
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.
How to Calculate IRR
The IRR is also a rate of return but is more flexible than the 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 |
-1000 |
1 |
400 |
2 |
500 |
3 |
600 |
4 |
700 |
In the above case, using the Excel function “IRR,” we obtain a rate of 36.4%.
The Bottom Line
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 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.