What Is the Internal Rate of Return?
Simply put, the Internal Rate of Return (IRR) is the average return that you earned on your money invested. It is expressed as this formula:
But as always, let’s break this down into simple math and really understand it using an example:
You put in $100 as your initial investment
$20 for each the following 3 years
At the end of year 4 your ending value is $200
A computer (aka Excel) uses an interative process to find the return that does this:
The concepts behind this example are based on a great post from Property Metrics. Without that post, I would have never understood IRR.
Fun Fact: The internal implied values in columns C an are where the name Internal Rate of Return came from! Of course the implied internal values are not the actual values of the portfolio, but it is how the IRR is derived.
You can input the initial $100 contribution, $20 cash flows, and final value of $200 into Excel and use the XIRR function, you will get a return of 7.0149%.
See attached spreadsheet for example.
Excel XIRR Example
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