The term “IRR” is thrown around quite a bit by sponsors / gurus / the internet. It’s in all the pitch decks. It’s the result of every financial model that is supposed to make you excited. “We’re projecting a 33% IRR!!!” But do your eyes glaze over when you read it? What does it actually mean?
IRR stands for “Internal Rate of Return”. Kind of helpful / descriptive, but not really.
IRR is the annual rate of return on an investment. BUT, it is an output, NOT an input. You don’t say “I’m going to use an IRR of 8% in this model.” You say, I’m going to invest $100 in cash and I should get back $110 in in cash in one year, so my IRR is 10%. This is a highly simplistic example.
The IRR calculation over a one-year period is VERY easy. It’s just how much money you make divided by how much you started with. In the prior example its $10 / $100 (10%).
However, when you get into multi-year cash flows and paybacks, the calculation is not quite as easy. This is where people who understand the concept start to confuse everyone. They try to boil it down to a sentence using words like “net present value”, “compounding”, “discounted cash flows”, etc. What are they talking about??
BUT IT IS STILL A SUPER SIMPLE CONCEPT.
Imagine your IRR is 10% over two years. What that means is that you start with $100, and after one year you have $110. Because you did $100 times 10%. So you made $10 and now you have $110 at the end of year 1 / start of year 2. Simple!
So then in year 2, you have $110, and then you multiply it again by 10%, and you have $121. You can see this illustrated below.
The investment COMPOUNDS. What that means is that its 10% every year on the higher amount! It’s not just 10% a year on the initial amount. This is why the concept is a little confusing. The math is not simple. Intuitively, you would think that a 10% return on a 2 year investment would mean you make 20% of your money (not 21% like it is shown above). But that’s not it. The formula for calculating an IRR is highly complex. No one actually knows how to do it by hand. They just do it in Excel.
So how is it actually used in the real world? Someone tells you to invest $100 and then you’re going to get $150 back in 3 years. You can see that equates to a 14% IRR in the table below. What does this mean? It assumes you start with $100, and compound your money at 14% each year. This is what compounding means. Every year your investment is worth more than the prior year.
Compounding is the reason you cannot just say $150 / $100 = 50% return and then divide by 3, which would be 17%. Financial academia (nerds!) talk about how the IRR is what makes the net present value of the investment = $0. But then what is the net present value?! You need a stronger understanding of finance to make it make sense.
This is the highly simplistic (and still exactly correct) way to understand the concept of an IRR.