Understanding XIRR and CAGR With Key Differences

When it comes to evaluating the performance of your investments, understanding the right metrics is crucial. Two popular return measures are XIRR (Extended Internal Rate of Return) and CAGR (Compound Annual Growth Rate). Though both express investment returns as percentages, they calculate and interpret these returns differently.

This space will break down the key difference between XIRR and CAGR, how you can calculate them easily, and which metric is better suited for different investment scenarios. By the end, you’ll be equipped to make more informed investment decisions with a clearer understanding of these essential financial terms.

What is XIRR?

XIRR stands for Extended Internal Rate of Return. It is a percentage rate that makes the net present value of all cash flows from an investment equal to zero. In simpler terms, XIRR is the annualised return rate that an investment yields over its entire lifespan. The key inputs of XIRR are:

• All cash inflows and outflows from the investment during the holding period, positive or negative
• Timing of each cash flow – when it was received or invested
• Any proceeds from selling the investment in the end (called residual or terminal value)

The XIRR calculation factors in the dollar amounts and exact timing of all cash movements into and out of the investment. Thus, XIRR captures fluctuations and irregularities in value over the investment’s lifetime to measure returns accurately.

How to Calculate XIRR?

To calculate XIRR in Excel:

1. List all cash flows (positive and negative) with their exact dates.
   
2. Use the Excel function = XIRR(values, dates) where values are the cash flows and dates are the corresponding dates.
   
3. The result will be the XIRR expressed as an annualised percentage.

XIRR gives the most accurate picture of an investment’s actual return over time, enabling more informed decisions.

What is CAGR?

CAGR stands for Compound Annual Growth Rate. It measures how much an investment has grown on average each year over a set timeframe. CAGR makes some key assumptions:

• It does not factor in the ups and downs in value each year
• Any extra cash inflows or outflows during the period are ignored
• It does not consider the ending value of the investment if sold at the end

Essentially, CAGR smooths out any fluctuations in returns and shows the constant annual growth rate that would produce the overall increase from the beginning to the end value. This gives a simplified and easy-to-grasp growth percentage over the time period.

How to Calculate CAGR?

The basic CAGR formula is:

CAGR = (Ending Value / Beginning Value)^(1/n) – 1

Where:

• Ending Value is the value at the end of the time period
• Beginning Value is the initial amount invested
• n is the length of the investment time period.

CAGR shows a smoothed annual return but ignores volatility.

XIRR vs CAGR: Key Differences 

Now that we have understood what XIRR and CAGR are, here are the main differences:

Aspect	XIRR	CAGR
Cash Flows	Includes all cash inflows & outflows	Only beginning and ending values are considered
Timing	Accounts for the exact dates of each cash flow	Assumes smooth growth over the entire period
Volatility	Captures fluctuations and irregularities	Ignores volatility, assumes steady growth
Accuracy	More precise annualised return	Simplified average growth rate
Residual Value	Considers terminal/sale value	Does not account for residual or terminal value
Use Case	Best for irregular cash flows and actual returns	Useful for quick comparisons and benchmarks

Which is better, XIRR or CAGR?

Generally, investors should use XIRR over CAGR for investment analysis because XIRR more accurately represents returns.

However, CAGR serves as a quick benchmarking and comparison between opportunities. It works best for smooth investments with regular cash flows.

Key Takeaways

In summary, in CAGR vs XIRR comparison, both measure investment profitability, but in different ways. Understanding the differences allows applying them based on available information and analysis needs.

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FAQs

Is XIRR better than CAGR?

Yes, XIRR is generally more accurate and a better return metric than CAGR for investment analysis. This is because XIRR accounts for all interim cash inflows and outflows along with the timing and size of those cash flows. 

What does 20% XIRR mean?

A 20% XIRR means that the annualised internal rate of return or actual return rate realised on the investment is equal to 20% per year. This indicates that for the particular investment analysed over its timeframe, each year the rate of return after accounting for all cash inflows, outflows and their timing equates to an average of 20% per annum.