Used to analyze venture capital and private equity investments, internal rate of return, or IRR, is an indispensable tool in your investor toolbox. If you’re unfamiliar with IRR, understanding its basic mechanics may help you make better investment decisions long-term.
What is the Internal Rate of return (IRR)?
IRR is a metric that is used to estimate the annual growth rate of an investment. Unlike the various metrics used to measure investment performance, IRR takes into account the time value of money.
Technically speaking, IRR is the interest rate at which the net present value (NPV) of both positive and negative cash flows from an investment are equal to zero. NPV is the difference between the present value of cash inflows and outflows.
Because they usually necessitate multiple cash investments over the lifetime of the business with a single cash outflow at the exit, IRR is useful when evaluating venture capital and private equity investments.
How Can Internal Rate of Return be Used?
For investors, IRR can be used to determine whether or not to pursue an investment opportunity. First, however, a potential investor must establish the minimum rate of return he or she expects to achieve by investing in a particular opportunity. This is known as the required rate of return, or RRR. If the IRR of an investment is greater than the investor’s RRR, then the investment is a go. If the IRR is less than the investor’s RRR, the investment should not be pursued. Investment opportunities that have the greatest difference between IRR and RRR typically have more potential for profitability.
Calculating Internal Rate of Return
To calculate IRR, you would use the same formula that you would when calculating net present value, or NPV. An important thing to note here is that IRR is a percentage return while NPV is a dollar yield.
- = Net cash inflow during the period, p
- = Total cost of the initial investment
- r = Discount rate
- p = Number of periods
To solve, you would set the NPV equal to zero and solve for the discount rate (r) through trial and error.
Imagine that you own a T-shirt printing business. You sit down and estimate the costs and earnings for the next three years, then you calculate the NPV for your business at different discount rates. At a 5% discount rate, you come up with an NPV of $1500.
Because the NPV must be equal to zero, you must try a higher discount rate, perhaps 7%. After plugging in 7%, you determine a net loss of $1,000, which puts you in the negative.
With 5% being too high and 7% being too low, it’s reasonable to assume your discount rate should lie somewhere between the two.
You plug in 6% and find that your NPV equals zero, which leads us to conclude that your IRR is 6%.
Calculating IRR in Excel
Needless to say, calculating IRR by hand can be quite tedious. Fortunately, IRR can be quickly calculated in excel using the IRR function:
Simply input the initial cash flow into B1 (remember, this initial investment should be a negative value because it’s an outflow). Then, you’ll input the subsequent cash flow values for each period into the cells below the initial investment – these can be positive or negative.
After you’ve input all your cash flows, type the function command =IRR into the cell directly below all of the cash values you’ve input. Then you’ll highlight the values from top to bottom and hit enter. Your IRR percentage should appear in that final cell.
For the purposes of investing, we can easily compare different investment amounts using the same cash flows for each period. You’ll see that at a lower initial investment amount ($10,000), the IRR increases significantly. Similarly, for a larger investment amount, the IRR decreases, falling below zero.
What IRR Can’t Tell You
While IRR can be very useful in comparing investment opportunities, it does have its limits:
- It’s only applicable for investments that have an initial cash outflow followed by additional cash inflows
- It doesn’t measure the absolute size of an investment or its return
- It can’t be used if the investment generates interim cash flows
- It doesn’t consider outside factors (inflation, cost of capital, financial risk)
- It can’t compare investments with different durations
Of course, the actual rate of return an investment generates will vary from its calculated IRR. However, an investment opportunity with an IRR that is notably higher than the other options has greater odds of exhibiting positive growth versus those options.
The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.