Internal Rate of Return: Understanding the Pros and Cons for Predicting Investment Performance

Choosing sound investment options for your portfolio means understanding different ways potential profitability is calculated, and the internal rate of return (IRR) is just one of the many tools you can use when planning for your financial future. Use the following guide to learn just what the internal rate of return is, as well as the pros and cons for using it as a predictive method for your investments. 

Understanding the Internal Rate of Return

The internal rate of return is a formula individuals and firms use to analyze potential investments and their profitability. Simply put, it lets you determine the annual growth rate of the investment so you can determine if it’s a sound option for adding to your portfolio. This formula takes into account both cash flow and costs throughout a set time period, with a higher IRR rate providing better profitability. Due to its complex nature, the formula is typically calculated using accounting software designed specifically for determining IRR.

Some companies may use the internal rate of return to determine if they should move forward with capital improvement projects, while a REIT might use it to decide if a specific property is a sound purchase. Individual investors can also use the internal rate of return as a tool when looking at different ways to expand or diversify their portfolios.

Pros of Using the Internal Rate of Return

Time: The calculations for the internal rate of return can be adjusted for different lengths of time, which gives you a glimpse at potential outcomes in the short term and long term. By looking at net cashflow and expenses for each year, it can be easier to determine ongoing performance for an investment. 

No Hurdle Rate: The formula for determining the internal rate of return does not take the hurdle rate into account. This rate is the minimum rate of return required for investors to fund a project, and it’s difficult to calculate exactly. By leaving the hurdle rate out, the internal rate of return may provide a better snapshot at potential profitability each year. 
Versatility: The internal rate of return has many potential applications, from helping publicly traded companies make decisions about stock buyback programs to helping individuals determine if they should reinvest dividends. While the internal rate of return isn’t the only tool available, it provides unique insight into potential profitability.

Cons of Using the Individual Rate of Return

Just a Piece of the Story: Just like any metric, the IRR only provides one piece of the investment story. Relying on it alone won’t give you all the information you need to make an informed decision. For example, the IRR doesn’t take into account additional costs beyond the initial investment. While net cashflows might be represented over the selected time period, they won’t reflect changes in cost during that time period. This means profits could be significantly less in reality. It’s also important to remember that the IRR is not the same as ROI (return on investment), though the terms may be used interchangeably in some situations.

Difficult to Calculate and Interpret: For the individual investor, determining the IRR can be quite difficult. The formula requires you to set the net present value (the difference between the present value of cash inflow and outflow) to zero, and then solve for the internal rate of return using the cash inflow during the selected time, total investment costs, and number of time periods taken into account. If all that sounds too complicated, you can use software or spreadsheet formulas to help. After the calculation has been made, you’ll still need to interpret the results. This means taking into account the possibility of time periods with negative cashflows followed by those with positive cashflows, which can lead to the IRR having multiple values to evaluate. 

Fortunately for investors, companies specializing in different types of investments do the heavy lifting for you. This means you don’t have to rely on just the internal rate of return or any other individual metric to make a decision about future investments, and you won’t have to break out the scientific calculator to get a better picture of potential profitability. DiversyFund puts its team of experts to work analyzing the internal rate of return and other essential calculations when looking at assets for acquisition to help create a robust and diverse portfolio for its investors.

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