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XIRR vs CAGR
When assessing investment performance, two essential metrics frequently come into consideration: XIRR (Extended Internal Rate of Return) and CAGR (Compound Annual Growth Rate). These metrics are valuable tools for investors to evaluate returns and make informed decisions regarding their portfolios. However, it is important to understand the definitions and distinctions between them. In this article, we will explore the XIRR vs CAGR difference in financial analysis, highlighting when to utilize each metric for optimal insight.
What is XIRR?
XIRR, or Extended Internal Rate of Return, is a financial tool used to measure how well an investment is performing. It takes into account the timing and amount of money going in and out of an investment over time. Unlike other methods like CAGR, which assume regular cash flows, XIRR is useful for investments where money comes in and out at different times.
By calculating the rate of return that makes the value of all cash inflows and outflows equal, XIRR gives a more accurate picture of how profitable an investment is. This helps investors better understand their investment's true performance and make smarter choices.
Table of Content
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What is XIRR?
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What is CAGR?
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What are the Differences Between XIRR vs CAGR?
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What is the Formula and Numeric Example of XIRR?
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What is the Formula and Numeric Example of CAGR?
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What are the Limitations or Assumptions Associated with XIRR and CAGR?
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What are the Pros and Cons of CAGR vs XIRR?
What is CAGR?
CAGR, or Compound Annual Growth Rate, is a key number used in finance to show how much an investment grows each year over a certain period, assuming it grows at a steady rate. It is often used to measure how investments like stocks or mutual funds perform over time.
CAGR gives a clear, consistent way to measure growth, making it easier for investors to compare different investments. The formula takes into account the starting value of the investment, the final value, and how many years the investment has been held.
What are the Differences Between XIRR vs CAGR?
| Parameter | XIRR | CAGR |
| Meaning | The Extended Internal Rate of Return (EIRR) incorporates fluctuating cash flows, offering a more precise analysis compared to traditional IRR methods. | Compound Annual Growth Rate (CAGR) measures consistent growth over a specified period. |
| Calculation | EIRR relies on the precise timing and magnitude of cash flows, ensuring that all inflows and outflows are accurately reflected. | Calculation Method involves the initial value, the final value, and the period. |
| Timing | The method takes into account the exact timing of each cash flow, enhancing the precision of the return rate calculation. | Assumption is that the investment is made at the outset with no additional inflows or contributions throughout the period. |
| Cash Flows | EIRR is well-suited for evaluating investments with non-uniform or sporadic cash flows throughout the investment horizon. | Typically focuses on a single, lump-sum investment at the start of the period. |
| Investment Type | This method is particularly effective for assessing investments with periodic, irregular contributions, such as Systematic Investment Plans (SIPs). | Ideal for assessing the performance of investments that do not receive further contributions during the investment horizon. |
| Rate of Return | By factoring in the exact timing of all cash flows, EIRR delivers a rate of return that more accurately represents the overall investment performance. | Simplified Growth Rate that calculates the average annual return, assuming uniform growth over each period. |
| Complexity | The EIRR model is more intricate due to the need to account for the variability and precise scheduling of cash flows throughout the investment period. | Provides an Easier Representation by assuming steady, consistent growth across the entire time frame. |
| Accuracy | The methodology offers enhanced accuracy when dealing with investments that involve irregular or variable cash flows, providing a clearer picture of potential returns. | Limitations include its potential inability to fully represent investments with non-uniform growth patterns or periodic contributions. |
What is the Formula and Numeric Example of XIRR?
XIRR (Extended Internal Rate of Return) is a way to measure the return on an investment when the money goes in and out at different times. In Excel, you use the formula =XIRR(values, dates), where "values" are the amounts of money invested or received, and "dates" are the dates when those transactions happen.
XIRR is calculated using the following formula:
XIRR = (NPV (Cash Flows, r)/ Initial Investment)*100
Example
Let us say you invested Rs. 1,00,000 in a business on January 1, 2025. Then, on July 1, 2025, you added another Rs. 50,000. By December 31, 2025, you received Rs. 1, 60,000 back.
To calculate the XIRR:
Your values would be: -1,00,000, -50,000, and +1,60,000.
Your dates would be: January 1, 2020, July 1, 2020, and December 31, 2020.
By using the XIRR formula in Excel, it calculates the annual return on your investment, considering the exact dates of each cash flow.
What is the Formula and Numeric Example of CAGR?
CAGR, or Compound Annual Growth Rate, is a way to show how much an investment grows each year over a period longer than one year, assuming it grows at a steady rate.
The formula for CAGR is:
CAGR = (Ending Value / Starting Value)^(1 / Number of Years) – 1
Example
If you invested Rs. 50,000 in a mutual fund on January 1, 2025, and by January 1, 2030, the investment grew to Rs. 65,000:
Starting Amount = Rs. 50,000
Ending Amount = Rs. 65,000
Number of Years = 5
Using the formula, the CAGR would be about 5.4%.
This means your investment grew by an average of 5.4% per year over the 5 years, showing how much your money increased each year on average.
What are the Limitations or Assumptions Associated with XIRR and CAGR?
Both XIRR (Extended Internal Rate of Return) and CAGR (Compound Annual Growth Rate) are valuable metrics for investment analysis, but each has specific limitations and assumptions that investors should be mindful of:
Limitations of XIRR
Complexity: XIRR calculations are relatively complex and typically require specialized software or financial calculators to compute accurately.
Sensitivity to Input Errors: Small discrepancies in the dates or amounts of cash flows can significantly distort the XIRR result.
Assumption of Reinvestment: XIRR assumes that cash flows are reinvested at the same rate of return, which may not be feasible in practice.
Limitations of CAGR
Exclusion of Volatility: CAGR smooths out annual fluctuations in returns, potentially overlooking significant short-term risks or gains.
Assumption of Steady Growth: CAGR represents an average growth rate over a period, which may not accurately reflect the actual trajectory of returns, especially in volatile markets.
Limited Data Consideration: CAGR only considers the initial and final values of an investment, ignoring intermediate changes, contributions, or withdrawals during the period.
What are the Pros and Cons of CAGR vs XIRR?
Here is a comparison of CAGR vs XIRR in table format:
CAGR
| Pros | Cons |
| CAGR offers a straightforward way to measure the average growth rate over some time, making it easy to understand and use. | CAGR does not account for fluctuations or volatility within the period, which can be misleading when there are significant ups and downs. |
| It provides a consistent growth rate regardless of fluctuations, giving a smoothed and clear picture of overall performance. | It assumes constant growth, which may not reflect real-world conditions where growth can vary from year to year. |
| CAGR allows for easy comparison between different investments, assets, or companies by evaluating their growth over the same period. | CAGR only provides a final growth rate without revealing any details about the factors influencing the growth or the reasons for any inconsistencies. |
XIRR
| Pros | Cons |
| XIRR is useful when there are irregular or non-periodic cash flows (like investments or withdrawals), unlike traditional IRR, which assumes constant intervals between cash flows. | XIRR requires accurate input of both amounts and dates for each cash flow, and the calculations can be more complex than basic ROI or CAGR methods. |
| XIRR accounts for the exact dates of cash flows, providing a more accurate reflection of the actual return compared to standard methods like annualized return or simple interest. | XIRR assumes that cash flows are reinvested at the same rate of return, which might not always be realistic or achievable in real-world scenarios. |
| It's applicable for both individual and institutional investments, and is commonly used in financial analysis tools like Excel, making it easily accessible for various users. | Large or irregular cash flows can disproportionately affect the XIRR result, leading to misleading conclusions if not managed carefully. |
Conclusion
XIRR (Extended Internal Rate of Return) and CAGR (Compound Annual Growth Rate) are essential metrics in investment analysis, each serving distinct purposes. For investors using a stock market app, both XIRR and CAGR can offer valuable insights into portfolio performance, assisting in data-driven decision-making for better investment outcomes.
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FAQs on XIRR vs CAGR
What is XIRR?
XIRR (Extended Internal Rate of Return) measures the annualized return of an investment with irregular cash flows. It accounts for the timing of each cash flow, providing a more accurate return calculation.
What is CAGR?
CAGR (Compound Annual Growth Rate) calculates the annual growth rate of an investment over a specified period with the assumption of constant growth. It ignores fluctuations in returns and timing of cash flows.
When should I use XIRR?
Use XIRR when your investment has irregular or periodic cash flows (e.g., SIPs or lump sum investments). It considers the exact timing of each cash inflow or outflow.
When should I use CAGR?
Use CAGR for investments that have a steady growth rate and where cash flows are not irregular. It helps compare long-term growth rates of different investments.
How are XIRR and CAGR different?
XIRR accounts for the timing of each cash flow, making it more suitable for irregular investments. CAGR assumes constant growth and ignores cash flow timing, simplifying the calculation.
