Evaluating investments using IRR and calculating returns

Why do we invest? To generate financial returns of course! There wouldn’t be any point to starting a new investment if it wasn’t going to provide you a financial return. But how do you know if it’s a good return? What if it only provides you a return in 5 years time? Or a 15% dividend yield every year, but is worth half of what you paid for it in 5 years, is it still a good investment? What if it paid nothing in the first year, then 20% per year after that. Is that better than the previous example, or isn’t it?

So, enter Internal Rate of Return (IRR). Calculating IRR let’s you determine whether a particular investment provides a great return relative to your own personal hurdle rate. It also let’s you compare investments to risk-free cash returns, or a private equity investment, property or shares. In a professional sense, this is how I would determine whether a private equity investment was worth pursuing, as we had to generate returns above the requirements of our fund. If the investment’s IRR was too low, we would need to negotiate price generally, or move on from the investment.

So what is IRR?

IRR calculates your potential return using the cash flows of the investment against your initial investment. Since timing of the cash flows matters, cash received sooner is more valuable than cash received later. Intuitively, due to inflation, $1 received today is worth more than $1 received in 10 years. So IRR takes into account of this fact.

For a technical definition, Investopedia defines it as calculating a discount rate such that the net present value of an investment is zero. This implies the same thing as above, an investment today is worth the future cash flows discounted by a particular rate. That discounted rate, that’s IRR.

Simply, IRR is the potential return of an investment against the amount you’re investing. If cash investments yield 5% per annum, but your IRR of a new investment is >5%, then it returns more than cash. We’ll ignore risk for now, so you’d have to establish personally how much higher than cash returns your investment needs to yield in order to justify the risk.

What are the levers that impact IRR?

It’s important to note, since IRR is calculating a return both relative to your investment as well timing of cash flows you can have incredibly high IRR that means little in terms of actual returns. A 1000% IRR looks amazing on paper, but what does it actually mean? You can achieve 1000% IRR in multiple ways, for instance:

• $1 invested today, provides $160k return in 5 years – obviously the holy grail. No investment, massive return.
• $1 invested today, $1300 in 3 years. Shorter time frame, return is still massive, but not of the same magnitude.
• $1 invested today, $11 in 1 year.
• $1 invested today, $2 in 105 days.

What do you notice? 1000% means very little, outside the context of the time frames. Hence, for most decent investments, you always want to look at 5 years or more to assess the return.

The other thing you notice? the inverse. Returns trend downwards as the timeframe increases. It is significantly harder to maintain a high 20% IRR as the number of year’s increases. 20% IRR over 10 years is worlds apart from 20% IRR over 5 years, or 15% IRR over 10 years.

Returns all in the exit value versus annual cash flows

Lastly, IRR is happy to let you calculate a high return based on some future value, whereas until you’ve seen any actual cash your IRR is 0. What do I mean? If you received annual cash flows to get to a 20% IRR over 5 years, it differs to an investment where you received no cash flow, but a large exit value to get 20% IRR at the end of year 5 (or worse, it’s a valuation that implies it’s 20%, whereas you actually wouldn’t be able to realize the investment).

The difference between the two scenarios? If your investment goes bang, the first one received cash flows over the investment period, maybe having recovered the majority of their investment already. Realized IRR versus unrealized IRR is important to your own risk mitigation. Generally the investment where you’ve received the cash is better, since the exit value is often uncertain until you actually have completed the sale. Until then, it’s just a management valuation, and if you’ve been investing into listed holding companies long enough you’ll know management valuation says more about the forecaster than the asset being valued.

How to calculate IRR, what are the inputs

Now, in order to calculate IRR, you need the following:

• The initial equity investment – note: this isn’t the total price of the asset you’re buying. You might be using debt to buy the asset, and so some of it isn’t being funded by you. There are such things as levered and unlevered IRR to deal with this, but for now, we just need how much cash you’re investing as equity.
• Cashflows for the duration of the investment – you need the dates and the cash flows over the investment term. These are both positive returns (dividends/rent) as well as any further investments you need to make (capex/shareholder injections). You need to know the dates, unless you’re only doing it on an annual basis.
• The exit valuation of the investment – this is the expected realized exit value of the investment. You can use either pre-tax value or post-tax value. It depends on what you’re comparing it to. I used pre-tax in my professional work since it was consistent across investments for comparison, and your own tax situation/marginal rate/tax regime would determine your tax rate and it changes. For personal investments these days I calculate both pre and post.

Another comment on the exit valuation, I try to be conservative on the exit valuation. I don’t want to trick myself that I’ll suddenly increase the value of the asset acquired just because I bought it. What do I mean? If I bought the asset for $10 today and it makes $5 profit then I bought it at 2 times earnings. I’ll assume that I got it for a fair price. Therefore if I bought if 2x today, then I’ll sell it in 5 years time for 2x. Therefore if profit grew to $10 in 5 years, my new value is $20. This is to be conservative. I fully intend to increase the multiple and add value, but for IRR I want to make conservative assumptions. Therefore entry and exit multiple remains the same for the valuation.

Beware high multiples on exit valuation

Just be careful when you pay a high multiple! If you bought something for a 100x PE (looking at you Tech stocks!), then you cannot use 100x as the exit multiple. You may laugh at this, but I saw it happen a lot in the private equity space. It’s the first sign of exuberance, and generally a problem with too much capital sloshing around. Trust me, it ends badly.

Also, intuitively it makes no sense. 100x PE implies that the business will grow massively and currently the earnings are low. By growing massively it means that the earnings go up. If it achieves that growth it means that the high multiple was justified, at entry! It isn’t going to grow indefinitely at that rate. So in 5 years, a 100x PE stock will either have achieved the growth and probably be closer to a mature company, or it will have failed to reach the earnings.

Either way, it is no longer a high growth company and therefore the exit multiple must be adjusted to reflect this. Be conservative, look at mature companies in the sector and use the long term multiples not the current bubble.

So I’ve got cashflows, how do I calculate IRR?

The simplest method to calculate IRR, is to let Excel do it. If you fire up Excel, you can use two functions to calculate your IRR if you have the cash flows.

The first function is the simplest, =IRR(values,[guess]). Simply give it the column/row of annual cash flows and it does the rest. Don’t worry too much with the optimal guess input. This is too technical, but because of the mathematical methods to calculate IRR you sometimes cannot get an answer, you can use the guess input to assist.

So in an example, you’d have the following:

• $1000 as initial investment. This is inserted as a negative. Cash outflows are negative, inflows are positive for IRR calculations.
• 4 years of dividends, $50 for the first year, growing by 5% per year.
• Exit value in year 5 of 50% growth on initial investment, so $1500.

Putting in the function =IRR(A1:A6) gives you a result of 12.3%.

Note, blank lines are not counted as zero, they’re simply ignored and thereby reduce the years. So you need to actually type 0 in order to make Excel know this was a year of no dividends. Otherwise you’ll inflate the IRR since you’ve made returns arrive sooner by leaving it blank instead of zero.

What about date specific cashflows? Enter the XIRR function

The second method to calculate IRR, is the XIRR function. This let’s you be more specific on the timing of the cash flows instead of just annual. So if you’re receiving dividends quarterly, or more than 1 per year and at different months in the year, then you want to use the XIRR function.

=XIRR(values, dates, [guess])

This time, you have one array for the cashflows (values), and another array that corresponds to the dates that tie up to that cashflow.

This time your IRR is slightly lower at 11.4% (compared to 12.3% above) using the XIRR function. Why is this? because I placed all of the dividends towards the bank end of the investment, all of them are in the final 5 months of the investment. XIRR let’s you do this, instead of just assuming they’re annually placed through the term of the investment.

Conclusion

So now you can see how IRR is calculated in theory. This post carried on for long enough, so using it to assess an actual investment will be done in a follow-up post. The premise is similar except we’ll use the actual earnings and investment assumptions to show how IRR is calculated on an actual investment.

IRR is a highly useful tool, primarily to let me assess whether a new investment is worth pursuing versus just keeping it in a bank account or equities. Knowing the nuances of how it’s calculated and what to look out for let’s you gain a lot of insight into the forecast assumptions. The assumptions in many cases are more important than the actual IRR result, especially to see if someone is just being overly aggressive with returns. It is a highly useful tool, and one of the key metrics used in assessing new investments.