The Daily Technical #54: What is the difference between CAGR and IRR?

How to answer "What is the difference between CAGR and IRR?"

November 25, 2024

Good morning. Welcome to the 54th edition of The Daily Technical. You’re here for one reason so let’s dive in.

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OVERVIEW OF YESTERDAY’S QUESTION
What is the difference between CAGR and IRR?

The compound annual growth rate (CAGR) and internal rate of return (IRR) are both used to measure the return on an investment.

However, the calculation of CAGR involves only three inputs: the investment’s beginning and ending value and the number of years.

IRR, or the XIRR in Excel to be more specific, can handle more complex situations with the timing of the cash inflows and outflows (i.e., the volatility of the multiple cash flows) accounted for, rather than just smoothing out the investment returns.

CAGR is usually for assessing historical data (e.g., past revenue growth), whereas IRR is used more often for investment decision-making.

Common Mistakes

  1. Students often mix up inputs for CAGR and IRR. CAGR focuses on start/end values and time, whereas IRR deals with cash flow timing. Practice identifying the correct inputs for each scenario.

  2. Using CAGR for future projections or decision-making where IRR would be more appropriate. Clearly differentiate when to use each metric—CAGR for historical growth, IRR for evaluating investment options.

TL;DR

  • CAGR: Simple calculation with start/end values and years; best for historical growth.

  • IRR: Handles complex cash flow timings, ideal for investment decisions.

  • Use each metric in contexts where they excel—CAGR for assessing historical data, IRR for investment decision-making.

TODAY’S QUESTION
Is it bad if a company has negative retained earnings?

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