Investors are often faced with decisions, especially when comparing two potential investments. Knowing where to put your money comes down to understanding the desirability of investments relative to each other. Often that means looking at the IRR. What is the internal rate of return (IRR)? It is a tool that will help you make smarter decisions when it comes to choosing between investments.

New investors are unlikely to be familiar with IRR as a measure for valuing investments. This is a tool that the earlier you learn it the more powerful it becomes in your larger investment journey. Here’s an overview of IRR, how it is calculated, and what you need to know about using it to improve your ROI.

The definition of the internal rate of return

Internal rate of return is a method of calculating the future profitability of a potential investment. It is closely related to the net present value (NPV): the difference between cash inflows and outflows over a given period (more information below). The IRR examines the expected annual growth rate of an investment during this period.

The real purpose of IRR is to determine the “discount rate,” which is similar to the compound annual growth rate (CAGR) of an investment. When the CAGR acts as an average rate of return for an investment that is likely to fluctuate over time, it is calculated when you know the final total. With IRR, you work to determine the discount rate that makes an investment worth the cost of the principal. The higher the IRR, the more profitable the investment.

What is the IRR for?

The IRR is mainly used to compare potential investments. If investment A has an IRR of 12.5% ​​over five years and investment B has an IRR of 8.2%, it becomes clear that investment A is the most attractive option for an investor.

While this is a great tool for investors, IRR has its roots in corporate finance. It is used to justify the spending of company funds on capital projects. Businesses use IRR to determine whether a project will provide sufficient value to the business (or shareholders). If the IRR is high, it signals a good project. A lower IRR tends to indicate a project that may require reassessment.

The internal rate of return formula

As is the case with most investments involving an interest rate, there is a formula behind the IRR that allows investors to gauge the rate of return. This formula is as follows:

• NPV = net present value
• CFt = net after-tax cash inflows in a single period
• r = internal rate of return that could be obtained in alternative investments
• t = period of receipt of cash flow
• n = number of individual cash flows

Curious about the net present value (NPV)? Don’t worry, it’s just a different measure of IRR. While IRR measures the percentage of return on investments over time, NPV indicates the dollar value.

If you look at this formula with confusion, don’t worry. There are many excellent formulations and online calculators able to show you IRR, which means sparing you the calculations necessary to figure it out.

It’s also important to note that a compound interest calculator is not the same as an IRR calculator. To see an example of compound interest at work (compound annual growth rate), consult our investment calculator and play with the variables.

IRR vs NPV: what’s the difference?

As mentioned above, IRR and NPV tend to go hand in hand. They both revolve around looking ahead to the validity of a potential investment. When used as investment valuation tools, they often indicate the same result. Still, it’s important to know the difference.

• IRR is a better tool for a prospective valuation when there is a relatively equal chance of stability for each year of the investment. IRR uses the same discount rate and assumes the same level of risk. It is also better over a short to medium time horizon; generally 3 to 5 years. The higher the IRR is than the discount rate, the better the investment.
• NPV is a better tool for looking further into the future, especially when investments can be subject to volatility. NPV is also better for evaluating fund and index investments, where there are more contributors to an aggregate value. Likewise, if you have no idea what an investment’s discount rate might be, NPV can help you figure it out.

IRR and NPV are often two ways to achieve the same goal. It all depends on the type of investment you are evaluating and the variables you are familiar with.

Familiarize yourself with IRR by looking to the future

Looking to the long term means planning ahead to understand what you get out of the investments. What is the internal rate of return? It is a measure of the value of one investment over another. Not only can it tell you whether an investment is good or bad (profitable), it can help you put your money in better positions to exceed it. If you are faced with a choice of investments, the IRR will guide you to the best return on your investment by giving you a glimpse into the future of that investment.

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Keep in mind that IRR is only a tool for subjective analysis of the value of a future investment. It can give you clear information about whether an investment is worth considering, as well as the return needed to be worth it. Ultimately, it is up to investors to be diligent in comparing and contrasting investments when deciding where to put their money.