In todays email:

• 🤓 The 2 metrics I like - IRR and CAGR.

• ☝️ IRR explained in simple terms and sample calculations.

• 💸 CAGR explained in simple terms with example.

• 🆚 IRR vs CAGR.

Important Metrics

There's an old adage that says “if it doesn't get measured, it doesn't get improved”. This is so true not only in the world of investing, but also when you're trying to lose weight, trying to exercise, etc.

There are many ways to calculate how you are doing in the things you invest in, however I like to narrow it down to 2 metrics in particular.

• Internal Rate of Return (IRR)

• Compounded Annual Growth Rate (CAGR).

By now, many of you are glazing over and ready to stop reading. But don't do that. I'm trying to make this easy and something useful for you.

Each of these metrics has its own limitation, so I like to use both in combination. Many people talk about return on investment or ROI, but that does not take into account the length of time you are in an investment and the time value of money is super important.

Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is a widely used measurement and finance, commercial real estate, residential real estate, private equity, and so on. Most people that I talk to you really don't understand how it is used and how it is calculated and how to apply it to everyday investments. They don't have a deep sense of what it is measuring.

Here I will give you some basic understanding and some examples to make it more concrete. I am not going to get into the nitty-gritty (textbook definition of IRR is that it is the interest rate that causes the net present value to equal zero). Most people find this textbook definition of IRR difficult and near impossible to understand…including myself.  

So instead let’s look at a more intuitive interpretation of IRR.

IRR, or Internal Rate of Return, is like a magic number that tells us how good an investment is by showing us how fast our money grows. Imagine IRR as a special measuring tape for real estate investments. It tells you how fast your money grows over time, considering all the money you put in and all the money you get back, like rent and property sale profits. So, the higher the IRR, the better the investment is likely to be.

Said another way, the internal rate of return (IRR) for an investment is the percentage rate earned on each dollar invested for each period it is invested.

So instead of showing you a fancy formula of IRR, let's go directly to an example since we all have calculators and we all have Excel. You don't have to remember these formulas since we all have these tools 🛠️.

Simple IRR calculation using Excel.

Two examples are shown below. The first one (on the left), shows an initial investment of $100,000 and each year receiving $10,000 cash flow and in year five receiving the initial investment of $100,000 back plus the $10,000 return which equates to a 10% IRR.

To put it in more concrete terms, you invest $100,000 as a private lender into someone's real estate deal and they agree to pay you 10% interest only on your money and a five-year term at which time all your initial capital gets returned with your interest.

The second example (on the right), shows an uneven cash flow situation where you get $5000 the first year, $6000 the second year, $7000 the third year, $8000 the fourth year, and year five you get $9000 cash flow plus your initial hundred thousand dollars capital investment back. The equates to a 6.87% IRR.

In the first example, was very easy since it was 10% across-the-board, however with uneven cash flows it's not as intuitive and the IRR calculation makes it easy to determine your returns.

Simple IRR calculation using 10bii calculator.

Now let's do this calculation using the 10 Bii calculator which I discussed in a prior newsletter. It is a great app which you should definitely get on your phone and your computer.

We will use the uneven cash flow scenario.

1. Open up your calculator in first thing you wanna do is sent set the payments per year to 1 (typically it defaults at 12 since notes typically pay monthly). You can type in 1 and then press the orange button and then on the top right P/YR…payments per year (see pic below…I cut off the numbers to reduce size)

2. Then click the CFj button for cash flow (pic below).

3. The screenshot below is what you will see after you click the CFj button. Here is where you will type in your cash flow amounts and number of times that cash flow amount occurs. If you need more cash flow lines just click the “+” sign. The first line is the negative of the initial investment amount.

4. After you have input the cash flow amounts then simply press the IRR/YR button at the bottom right and the IRR will appear (6.867% in this case which rounds to 6.87%).

Compounded Annual Growth Rate (IRR)

The compound annual growth rate (CAGR) is a useful measure of growth over multiple time periods. It can be thought of as the growth rate that gets you from the initial investment value to the ending investment value if you assume that the investment has been compounding over the time period.  Although average annual return is a common measure, CAGR is a better measure of investment’s return over time.

The formula for CAGR is:

CAGR   =   ( EV / BV)^^{1 / n} - 1

where:

EV = Investment's ending value

BV = Investment's beginning value

n   = Number of periods (months, years, etc.)

Example:  Invest $1,000 in Fund XYZ for five years.

Year    Ending Value

   1             $   750

   2               1,000

   3               3,000

   4               4,000

   5               5,000

We can calculate the CAGR of the investment as:

CAGR = ( 5,000 / 1,000)^1/5  - 1 = .37973 = 37.97%

Comparing IRR to CAGR

IRR says nothing about what happens to capital taken out of the investment whereas the CAGR does. See example below. The one is our original example with $10,000/year cash flow and capital returned in year 5. The total cash flow is $150,000 and IRR is 10%.

Now let's compare this to a CAGR calculation where some of the cash flow goes towards principal and some towards interest (return of investment versus return on investment, respectively).

Let’s take an example to illustrate. Suppose we have the following series of cash flows that also generates a 10% IRR (see tables below):

Now, notice in this second example, how the outstanding internal investment decreases by $5,000 in year 1, $5500 in year 2, etc. This process of decreasing the outstanding “internal” investment amount continues all the way through the end of year 5. This extra cash flow results in capital recovery, thus reducing the outstanding amount of capital we have remaining in the investment.

So what do I mention this? Let’s take another look at the total cash flow columns in each of the above two charts. Notice that in our first example the total cash flow was $150,000 while in the second chart the total cash flow was only $144,475.

But wait a minute, I thought both of these investments had a 10% IRR? Well, indeed they both did earn a 10% IRR, as we can see by revisiting the intuitive definition of IRR:

The Internal rate of return (IRR) for an investment is the percentage rate earned on each dollar invested for each period it is invested.

The internal rate of return measures the return on the outstanding internal investment amount remaining in an investment for each period it is invested. The outstanding internal investment, as demonstrated above, can increase or decrease over the holding period. IRR says nothing about what happens to capital taken out of the investment. The IRR does not always measure the return on your initial investment. You need to know what buckets 🪣 the cash flow are going into.

SUMMARY: The Internal Rate of Return (IRR) and Compounded Annual Growth Rate (CAGR) are good measures of investment performance. However, it is important to make sure that you interpret the data in the right way to avoid coming to the wrong conclusions. Hope this helps.

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