IRR (Internal Rate of Return) - The Definitive Guide
Our guide explains what IRR is, what it means, how it compares with other financial return metrics and how to calculate it
Updated 10 April 2021
Know This First - What is IRR?
Internal Rate of Return (IRR) is one of the metrics used to determine how fast something is growing – whether that's a company, a project or a share. IRR is used in a lot of the finance world to compare and contrast one investment to another.
IRR is one of the many tools investors can use to analyst investments. Other notable tools include ROI, CAGR, Price to Earnings Ratio (PER), Enterprise Value to Revenue Ratio (EV Rev), to name a few.
IRR is one of the many tools investors can use to analyst investments. Other notable tools include ROI, CAGR, Price to Earnings Ratio (PER), Enterprise Value to Revenue Ratio (EV Rev), to name a few.
Why is IRR used?
IRR can convert a complex investment or project into a single number that can be used to compare against other investments. If you have two different companies doing different things, it can be difficult to know which one is doing better with so many differences. IRR allows you to isolate the specific company and analyse its merits individually – which can then be used to compare with other companies with only one number.
In business or investing in general, a "hurdle rate" may be applied before investing. A hurdle rate is a rate at which a particular investment will be undertaken (it could be 5%, 10%, 20% etc.). Most companies do this to ensure that the project they're taking on isn't too low return, which would not meet the objectives they need to reach for their end of year targets.
To outline IRR in detail, our guide covers:
In business or investing in general, a "hurdle rate" may be applied before investing. A hurdle rate is a rate at which a particular investment will be undertaken (it could be 5%, 10%, 20% etc.). Most companies do this to ensure that the project they're taking on isn't too low return, which would not meet the objectives they need to reach for their end of year targets.
To outline IRR in detail, our guide covers:
IRR Explained in a Nutshell - Our Juice Stand Example
We believe IRR is best explained in an example. We use the case of James and his juice stand. James plans to set up a fruit stand to sell at the Auckland markets. His dilemma is whether to set up an orange juicing station or a lemonade stand. Both are relatively different products, but he can't do both and therefore wants to pick which one is best.
Calculating the IRR of the Orange Juicing stand:
As you can see from the orange juicing stand example:
Calculating the IRR of the Orange Juicing stand:
- A juicer would cost James $250,000 (expensive, but big enough to manage the demand of multiple customers at once) to buy the orange juicer that he needs to use for juicing the oranges.
- This $250,000 would be the initial upfront cost that is necessary for James to start selling orange juice.
- Each year, James is likely to profit from selling orange juice at the Auckland market. In the first year, he'll get $100,000 profit and $50,000 each year after that for the next four years.
- James is likely to stop selling my orange juice and retire after year 5. This is because his juicer is burnt out and doesn't work anymore.
- After putting in the numbers and calculating the upfront cost ($250,000) and benefits ($100,000, $150,000, $200,000, $250,000 and finally $300,000, in total, by year five), analysis suggests that the IRR for the orange juicing stand is ~57%.
- In other words, if James was to invest in any other project (including the lemonade stand), the lemonade stand would have to have an IRR that is higher than 57% for him to make more money on it.
As you can see from the orange juicing stand example:
- IRR typically takes the initial cost of a project ($250,000 for the juicer) and
- Estimates future cash flows ($100,000, $150,000 etc.) to work out the average growth rate the investment would be expected to grow at
- In this example, it's 57% each year
- Note: We have configured the table to three significant figures (i.e. -250 and 100) rather than -$250,000 and $100,000 etc.
Formula and Calculation of IRR
The easiest way to calculate IRR is to use an IRR calculator. However, this isn't always relevant for workplace situations. For this, Excel is the best option - it's quicker and is relatively easy to calculate than any alternative.
How to set up the IRR calculation in Excel
How to set up the IRR calculation in Excel
- In one row – put the year (starting from 0 and continuing for however long you're working it out as)
- In another row – put the profit or loss in (negative being a cost – like the orange stand, and positive being the money from the business – e.g. the profits from selling orange juice).
- To calculate IRR, insert the formula in a new cell that looks like: "=IRR(Values)". Values is the range of positive and negative numbers in the second row (-200,000, 100,000, 150,000 etc.).
- You can download an Excel example here to see the formula in action.
IRR - When to Use It, What it Indicates and Limitations
When to Use IRR?
You would typically use IRR when comparing projects in business. However, you could also use IRR when calculating share portfolio returns over time. IRR is most similar to Compound Annual Growth Rate (CAGR) – which is a way to figure out how much your investment has been growing each year.
For example, if you've been investing in Sharesies for the last five years and want to know what the IRR of a particular share has been over time. To do this, you would hypothetically be able to:
For example, if you've been investing in Sharesies for the last five years and want to know what the IRR of a particular share has been over time. To do this, you would hypothetically be able to:
- Insert in the dollar amount of initial investment in (remembering the negative sign)
- Add any dividends received during your holding period
- Add the amount you got from selling it at the end (as a positive sign).
- Using Excel, it would provide you with the IRR for that specific share, which you could then compare with other shares in your portfolio (doing the same calculation for each of them).
What IRR Tells You
IRR is a valuable indicator for finding the most profitable (or move attractive) investment decision, whether on a project, share or fund to invest in. Most funds provide either IRR or CAGR figures to compare, and while there are other factors to consider alongside IRR, it can be a quick test to understand how a particular share is doing compared to its peers.
Limitations of IRR
- Because IRR is a single number, it doesn't tell you much else about the investment.
- For example, the IRR calculation doesn't take into account when the profits occur.
- The investment could provide a substantial positive return in the first year or be unprofitable for years before it returns a profit. For example, two completely different shares may produce a very similar IRR.
IRR Comparison Example - Share A vs Share B
As you can see from Share A, the profit in years 1-4 were steady and paid back in the form of dividends. It cost $20 to buy and was sold for $25 at the end of year five. The overall IRR of Share A is 12%.
Looking at Share B, there are no profits (and no dividends) provided in the first five years, so the cash flow in those years is zero. However, the share cost $50 to buy and returned $80 at the end of year 5. The overall IRR of Share A is 12%.
By comparing Share A and Share B, it's clear that both shares are very different in their return profile, profitability, dividend payout and relative risk (alongside cost to buy and sell). However, both shares have the same IRR.
Know This: IRR can identify the rate of return of an investment, but it misses key features as identified above. Using IRR can be a quick way to compare different investments, but it doesn't necessarily capture the wider picture. Other metrics can provide this information (from financial statements to revenue or profitability metrics).
Looking at Share B, there are no profits (and no dividends) provided in the first five years, so the cash flow in those years is zero. However, the share cost $50 to buy and returned $80 at the end of year 5. The overall IRR of Share A is 12%.
By comparing Share A and Share B, it's clear that both shares are very different in their return profile, profitability, dividend payout and relative risk (alongside cost to buy and sell). However, both shares have the same IRR.
Know This: IRR can identify the rate of return of an investment, but it misses key features as identified above. Using IRR can be a quick way to compare different investments, but it doesn't necessarily capture the wider picture. Other metrics can provide this information (from financial statements to revenue or profitability metrics).
IRR Benchmarks
- IRR is used in a wide number of roles in the finance world. From fund managers to venture capital to private equity, IRR (or CAGR) is a useful benchmark for comparing performance and tracking how the fund is doing overall.
- Below is a typical guide for the average IRR that each specific asset class looks for over the long term (more than ten years).
- The reason why a long term view is taken is that some investments take some time to realise, or for the investment ideas to play out in the real world (e.g. if you think the share price of Zoom will do well during the COVID-19 pandemic, it may take six months before that starts to be reflected in the share price).
Typical IRR by Asset Class
Expected and historical IRR ranges by asset classes, as we detail below:
1. Venture Capital - IRR range: 20-30%
2. Private Equity - IRR range: 20-30%
3. Index Funds / Public Equity - IRR range: 9-10%
4. Bonds - IRR range: 1%-5%
5. Cash - IRR range: 0-1%
Know This: Investing based on IRR
1. Venture Capital - IRR range: 20-30%
- Venture Capital is one of the riskiest asset classes to invest in, given the early-stage nature of young companies.
- There are no guarantees the company will survive and continue to operate in the future.
- As a result, most Limited Partners (LPs are entities who provide the money to VC funds) typically look for IRRs over 20%.
- If these investors wanted a safer investment, they could invest in the S&P500 and get 10% - so they look for greater returns above what they could get in the public markets (for less risk).
- These LPs also invest in VC to diversify their holdings, in case one of their asset classes (e.g. S&P 500) falls significantly.
- It's important to note that the top 25% of the VC market will significantly outperform the bottom 75% (the top 25% is likely to have IRRs greater than 40% for their funds).
2. Private Equity - IRR range: 20-30%
- Like Venture Capital, PE firms use a Leveraged Buyout Model (LBO) to acquire underperforming firms, improve them, and then sell them in 5-7 years.
- This investing style is typically higher risk (because of the high debt levels) and cost more to investors (through management fees and carry). As such, the typical IRR targets for these firms is >20%.
- Mirroring the characteristics of VC, the top 25% of the PE market will significantly outperform the bottom 75% (the top 25% is likely to have IRRs greater than 40% for their funds).
3. Index Funds / Public Equity - IRR range: 9-10%
- Investing in index funds like the S&P 500 have returned a 9-10% IRR throughout its lifetime. This is typically the benchmark for many fund managers and seen as the marker for a lot of funds.
- The "hurdle rate" mentioned earlier could be set at this level, as most companies are comfortable with the risk levels associated with index funds such as the S&P 500.
4. Bonds - IRR range: 1%-5%
- Typically a bond will have an IRR of approximately 1-5% IRR depending on the bond's risk (government, company, junk bond).
- It's more common in the current low-interest-rate environment to have bonds sit in the 2-3% IRR range. Our bond guide explains more.
5. Cash - IRR range: 0-1%
- Cash typically has low to zero IRR, as it inherently doesn't generate any cash flows.
- Inflation is one of the things that makes cash a particularly poor asset to hold in the long term.
- Inflation impacts other investment classes too, given cash doesn't generate anything, but it is significantly worse for cash as the real return (real = inflation-adjusted) is negative over time.
Know This: Investing based on IRR
- Given the nature of calculating IRR, it can be relatively difficult to ascertain for investments and is not typically used in retail investors' decision-making.
- An easier way to work out the attractiveness of a share or asset is by using ROI, CAGR or P/E Ratios.
- IRR typically requires you to forecast future cash flows, which a retail investor may have trouble doing if they do not understand the business or the market.
- Most participants in the finance industry use IRR (especially in private capital markets, where investments aren't easily tracked through live prices on a share exchange).
IRR - Frequently Asked Questions
Is IRR the same as ROI?
IRR and ROI are related to an investment's return rate but differ in what they mean. IRR focuses on the interest rate that you would need for your costs to equal your profits. In contrast, ROI concentrates solely on the difference between the ending investment and starting investment.
What is a good IRR?
What is typically "good" will depend on what asset class you're comparing it to (cash, bonds, shares, private vs public etc.). Typically IRRs >10% are considered good, with IRRs >20% as excellent.
