The Internal Rate of Return (IRR) may be one of the most frequently cited metrics in the world of finance. Amazingly, given its significance, I find that many people cannot properly describe how it works. Definitions of the IRR are also glossed over in the media and elsewhere as a complex calculation. To make my point, a recent article in the WSJ described it as follows:
The internal rate of return is the key performance metric published by private-equity firms. A percentage that measures annualized returns, the IRR is based on a complex set of numbers tied to fund cash flows. Investors use IRR to choose which funds to invest in. [1]
It might be that it would take too much text to define the IRR each time it is referenced, but it doesn’t mean that you should not understand it thoroughly. The last sentence in the quote above should be incentive enough. With that in mind I thought it would be beneficial to have one page on ASM that links to the various IRR-related articles.
The first three posts that follow are likely the most important as it relates to this topic. The fourth article listed is a simple exercise that provides a little more context.
The IRR Formula Explained. Start here and be sure to work through the math described in the article (none of it is complex). There is also a video on the page that will walk you through the math step by step.
Excel: =XIRR vs. =IRR. If you are new to Excel and finance you will come across the =XIRR() function and find yourself wondering why it generates a different outcome when compared against the =IRR() function. This post describes the discrepancy and explains when to use one or the other.
Excel: =XIRR vs. =IRR (continued). More detail on the post above.
Determine the Proceeds Required to Achieve a Specific IRR. How to calculate the the cash flows necessary to meet a specific IRR hurdle rate.
Why is understanding the math important? You might be surprised by the frequency with which these functions are used incorrectly in financial models. If you do not understand it, you will not have the ability to audit models (like a distribution waterfall) that rely heavily on the =IRR() and =XIRR() functions.