In order to be a successful investor, it’s important that you understand how to measure the viability of current and potential investments. Before you invest in anything, doing your due diligence is a crucial part of the process. While there are different metrics out there that lend themselves to measuring the health of an active investment, it’s important that you know how to use those that measure the viability of potential investments. One such commonly used metric is the Internal Rate of Return, often referred to as the IRR. Knowing what IRR is and how to apply it to potential investments can help you make a more educated decision about what to do with your money.
What Is an Internal Return Rate?
The Internal Return Rate (IRR) is a tool that financial professionals use in order to estimate the profitability of potential investments. The IRR is the discount rate that makes the Net Present Value (NPV) of all cash flows equal zero.
The Internal Rate of Return formula is as follows:
In this formula, Ct is equal to net cashflow during the period (t), C0 equals the total initial investment cost, IRR is of course the internal rate of return and t is equal to the number of time periods.
To determine the IRR, you would begin by setting the NPV equal to zero. When determining the initial investment, you will always have a negative number. That is because the initial investment is a measurement of cash outflow. Every subsequent cashflow can be either positive or negative, depending on whether the investment will require more capital (more outflow) or will generate a profit. Since the formulaic approach to determining IRR is so difficult, most investors rely on a program such as Excel.
Fortunately, Microsoft incorporated an IRR calculation function into Excel, so you can rely on the program to do all of the actual calculating for you. In order to access the IRR function on Excel, simply click on the “Formulas Insert (fx) icon.” You can then simply plug the numbers you have on hand into the labeled fields and let the program calculate the IRR.
When you’re looking at the final results of IRR calculations, bigger means a higher return. If an investor was given a list of three potential investments, he or she would determine the desirability of those investments based on their IRR. The list would start with the highest internal rate of return and proceed to the lowest.
Let’s take a look at a hypothetical investment in order to get a better understanding of how to determine the IRR of a potential investment opportunity. For the sake of this hypothetical situation, we will assume that you want to determine the profitability of an investment based on returns every 12 months.
The initial investment for this hypothetical investment is $250,000. In the first year, the investment provides a return of $100,000 after taxes. That investment generates an additional $50,000 each of the following years, culminating with a $300,000 return after the fifth year. Based on the IRR formula, this investment provides an IRR of 56.72% which is remarkable.
When To Use IRR
There are a variety of reasons to use the IRR formula. In many cases, businesses will use IRR to compare the profitability of starting a new operation to the potential profitability of expanding existing operations. Corporations also rely on IRR when evaluating stock buyback programs.
Understanding how to apply the internal rate of return to an investment does require you to input proper assumptions. However, once you have obtained information about the investment with which you are comfortable, you plug the numbers into the equation and get a good idea about how the potential viability of the investment. To be clear, the assumptions behind the formula are key. Adding IRR to your analyses can help you make more informed decisions and more successful investments.
Adam Luehrs is a writer during the day and a voracious reader at night. He focuses mostly on finance writing and has a passion for real estate, credit card deals, and investing.