XIRR Vs. CAGR: Meaning & Calculation

When it comes to measuring an investment's performance, several metrics are used. Two of the most popular ones are XIRR and CAGR.

Extended internal rate of return XIRR stands for Extended Internal Rate of Return, while CAGR stands for Compound Annual Growth Rate. Understanding the concept of CAGR vs XIRR provides investors with a way to calculate an investment's annualised return over time. 

While they may seem similar, investors should know some key difference between xirr XIRR and cagrCAGR. Today, we will discuss the intricacies of these two metrics and their advantages and limitations.

Topics Covered :

• What is CAGR?
• Calculating CAGR With an Example
• What is XIRR?
• Calculating XIRR With an Example
• XIRR vs CAGR: Which One is Better?
• Conclusion

What is CAGR?

CAGR, or compound annual growth rate is a commonly used metric in finance to measure the annualised rate of return of an investment over a period of time. It considers the compounding effect of returns and provides a clear and consistent way to compare the performance of different investments. 

This metric is particularly useful for long-term investments as it smooths out short-term fluctuations and accurately represents its overall performance.

Calculating CAGR With an Example

Calculating this with an example is a great way to illustrate how this metric works. Here's how you can explain it:

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Let's take a closer look at how to calculate this in the context of the Indian stock market. Imagine you invested in a specific stock in 2010 and want to determine its annualised return over the next five years.

In 2010, you purchased shares of ABC Ltd for ₹1,000 per share. Over the next five years, the value of your investment evolved as follows:

- End of 2011: ₹1,200 per share

- End of 2012: ₹1,350 per share

- End of 2013: ₹1,600 per share

- End of 2014: ₹1,700 per share

- End of 2015: ₹2,000 per share

To calculate the compound annual growth rate, you'll need the starting value (₹1,000), the ending value (₹2,000), and the investment period (5 years).

CAGR = (Ending Value / Beginning Value) ^ (1 / Number of Years) - 1

CAGR = (₹2,000 / ₹1,000) ^ (1 / 5) - 1

CAGR = (2) ^ 0.2 - 1

CAGR = 0.1487 or 14.87%

So, in this example, the compound annual growth rate for your investment in ABC Ltd in the Indian stock market over those five years is approximately 14.87%. This means your investment grew at an annualised rate of 14.87% during that period.

What is XIRR?

Extended Internal Rate of Return considers the timing and size of cash flows within the investment. This means that XIRR not only considers the final value of an investment but also factors in the irregular cash flows that occur during the investment period. 

As a result, extended internal rate of return provides a more accurate measure of an investment's performance, especially for investments with fluctuating cash flows.

Calculating XIRR With an Example

Let's delve into the concept of XIRR by applying it to an investment scenario. Imagine you made a series of investments and received returns over a specific period.

In this example, let's consider an investment in mutual fund:

- On January 1, 2020, you invested ₹50,000.

- On July 1, 2020, you added ₹30,000 to your investment.

- On January 1, 2021, you received a dividend of ₹5,000 from the fund.

- On July 1, 2021, you made another investment of ₹20,000.

- Finally, on January 1, 2022, you redeemed your investment, receiving ₹85,000.

To calculate the extended internal rate of return for this set of cash flows, you need to consider the exact dates of each cash flow. In this case, we have transactions occurring at various points during the investment period.

Using a financial calculator, spreadsheet software, or specialised financial software, you can find that the calculated Extended Internal Rate of Return for these cash flows and dates is approximately 12.34%.

This extended internal rate of return represents the annualised return, considering both the size and timing of the cash flows in the context of your mutual fund investment in India. It gives you a more accurate measure of your overall investment performance, accounting for the irregular nature of cash flows in this scenario.

XIRR vs CAGR: Which One is Better?

Extended internal rate of return, with its astute ability to integrate the timing and quantum of cash flows, positions itself as a robust measure, particularly adept for investments characterised by variable cash flows, such as those encountered in real estate or private equity ventures. This metric incorporates the diverse inflows and outflows, presenting a holistic view of the investment’s performance.

Conversely, compound annual growth rate presents a streamlined, potent analysis, emphasising deriving the mean annual growth rate between an investment’s inception and culmination points. It shows the trajectory of an investment, making it particularly suitable for scenarios with consistent cash flows, such as those observed in stock market investments or mutual funds.

Navigating the choice between XIRR and compound annual growth rate depends on the specificities of the investment under question and the investor’s prioritisation of information. 

While XIRR offers a detailed, time-weighted return perspective, CAGR provides a simplified average growth rate over the investment period.

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Conclusion

While both XIRR and CAGR are important metrics for evaluating investment performance, they have different purposes, strengths and limitations. It is important to understand the differences between these metrics and use them appropriately to make informed investment decisions.