XIRR and CAGR are two of the most common metrics for calculating returns on investments. While both are useful and effective, they vary in terms of their applications and calculations. Every investor must know these differences to strategise their investments and achieve financial goals.
The following sections will explore strategies that will help you achieve your financial goals. This blog will explore XIRR vs CAGR, differences, calculation methods, pros and cons, etc.
What is XIRR?
XIRR stands for Extended Internal Rate of Return. This financial metric is widely used to calculate an investment's performance based on the amount and timing of cash flows during a period. Since it also uses multiple periods and irregular cash flows, it becomes a valuable tool for investment analysis with complex patterns. It comprehensively measures an investment's profitability by calculating the return rate that nullifies the present value of all cash outflows and inflows. Investors can use the result to make more informed decisions.
XIRR calculates returns on investment tools with multiple periods and irregular cash flows. To calculate the metric, you need to create a cash flow table in Excel that includes initial investments and annual dividends. It includes values that show the cash inflows and outflows and dates when these cash flows occur.
For instance, if you invest Rs 1 Lakh in a business on January 1, 2024, and invest Rs 50,000 more on July 1, 2024, you will receive Rs 1,60,000 on December 31, 2024. The values to enter in the XIRR formula using Excel are as follows:
Dates: 01/01/2024 (date of first investment), 01/07/2024 (date of second investment), 31/12/2024 (date of cash inflow)
Enter these dates and values in the XIRR formula to calculate the percentage. It indicates the annualised return on investment based on the specific cash flow timing.
XIRR formula in Excel is: = XIRR (value, dates, guess)
CAGR stands for Compound Annual Growth Rate, another important metric for analysing an investment. It works by measuring the annual rate of an investment's growth through compounding over a specific period. The metric is often used to assess the performance of investments with constant growth patterns, such as mutual funds and stocks. Based on the results, investors can compare various investment options and finalise their decision.
Formula and Calculate CAGR with an Example
Suppose, on January 1, 2020, an investor invests Rs 10,000 in a mutual fund with an annual payout of Rs 500. If the investor reinvests the dividends in the fund, the mutual fund's value will be Rs 14,000 on December 31, 2024. Here is the formula to calculate CAGR in this situation:
CAGR = (Ending Value / Beginning Value)^(1/n) – 1
Here, n is the number of years in the investment period
CAGR = (14,000/10,000)^(1/5) – 1 = 0.0679 or 6.79%
Clearly reflects an investment’s annual growth rate without fluctuations
Especially useful for investments like SIPs with multiple cash flows
Especially useful for comparing the performance of various investments over a period
Cons:
More complex calculations
Does not include cash flow timings
Error-prone if the cash flows are not correct
Inaccurate results for investments with multiple cash flows
XIRR vs CAGR: Which One is Better?
Both CAGR and XIRR are valuable tools for measuring returns and analysing the performance of various investment options. It is crucial to choose the right one for each investment type.
When calculating returns using XIRR vs CAGR, it is important to use one that best suits the fund’s cash flow and investment patterns. XIRR is more appropriate for funds with irregular cash flows. It accurately measures the investment’s annualised return while considering the amount and timing of each cash flow. Conversely, CAGR is suitable for funds with regular cash flows. It simply measures the average annual return of an investment over a period.
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Conclusion
Both CAGR and XIRR are useful tools for measuring investment returns, each with pros and cons. While CAGR is a simple method for calculating an investment's average annual growth rate, XIRR is more complex and reflects the amount and timing of cash flows.
Frequently Asked Questions
1. Is CAGR always positive?
No, CAGR can be negative if the investment’s value declines over time.
2. Why is XIRR preferred over CAGR for SIPs?
XIRR accurately measures SIP returns for multiple cash flows at irregular intervals, which CAGR does not account for. Thus, XIRR is preferred over CAGR.
3. How does XIRR handle irregular cash flows?
XIRR handles irregular cash flows by accounting for both the magnitude and timing of cash flows.
4. Can CAGR be used to compare different investments?
Yes, you can use the CAGR method to measure and compare various investment returns.
5. When should I use XIRR instead of CAGR?
Use XIRR if you invest in an instrument with multiple cash flows at various intervals. CAGR is more appropriate for one-time investments.
6. Which is more accurate, XIRR or CAGR?
XIRR is more accurate than CAGR as it accounts for multiple cash flows and irregular intervals, while CAGR assumes a constant annual growth rate.
7. Is 30% XIRR good?
Yes, a 30% XIRR is considered excellent, especially if sustained over a long period. It signifies high returns on investment.
Katyaini is a finance expert with a focus on the non-banking financial sector, bringing over 8 years of experience in NBFC. She specializes in simplifying complex financial concepts for readers, helping them navigate the NBFC landscape. Outside of work, she is passionate about travelling.
