As you’ve probably noticed by now, there are quite a few different ways to find and track the value of your overall portfolio as well as all the various different investments it contains — stocks, valuables, crypto, and beyond.
Each has their differences, their upsides, their downsides, and their best use cases.
In this guide, we’ll talk about one of the more accurate methods for evaluating portfolio value: internal rate of return.
Follow along as we define what that means, how to calculate it, when to use it, and even a hot tip on the best software for automatically finding the internal rate of return of your entire investment portfolio.
Defining Internal Rate of Return (IRR)
Internal rate of return (IRR) is a discount rate. In the investing world, a discount rate is used to define the current value of future cash flow. When IRR is applied to the assumed cash flow of an asset, it should result in a net present value (NPV) of zero — more on that term later.
At its core, IRR measures annual growth rate, which demonstrates the potential return an investment may produce.A 20% IRR shows that an investment should yield a 20% return, annually, over the time during which you hold it. Typically, higher IRR is better IRR.
And because the formula includes NPV, which accounts for cash in and out, the IRR formula is even more accurate than its common counterpart return on investment.
What’s with the “internal” part of the moniker? It’s called this because it doesn’t account for some external factors, such as inflation, cost of capital, etc. By eliminating outside considerations, IRR creates a situation where the profitability of different investments can be compared on an even playing field.
IRR vs. Return on Investment (ROI)
Return on investment (ROI) is somewhat similar to IRR.
ROI measures the total return of an asset over its entire lifetime by comparing its presumed selling price to its purchase price. It doesn't take holding time into account at all. So while the numbers should be similar over the course of the first year, they’ll grow further and further apart as years pass.
While it’s less accurate for longer periods of time, ROI is used to understand the potential value of investments more often, because it’s much easier to calculate than IRR.
IRR vs. Net Present Value (NPV)
Net present value (NPV) is a calculation used to identify the current value of the cash flow an investment will produce in the future, which makes it a key metric for identifying which assets are most profitable.
NPV compares the present value of cash inflows to the value of cash outflows, in dollars. It is used as a part of the IRR formula to help investors understand the yield on a potential investment.
IRR vs. Modified Internal Rate of Return (MIRR)
Modified internal rate of return (MIRR) assumes that any positive cash flow is reinvested at the original cost of capital, while the traditional IRR that we’re talking about here assumes reinvestment at the IRR itself.
So while MIRR is ultimately more accurate for understanding investment profitability, it’s even more complex to calculate and is therefore used even less often than IRR.
IRR Use Cases
IRR is most often used to find the return on investment opportunities that require an initial cash outlay and are followed by multiple cash injections over the course of more than one year.
Personal Investments
Of course, we wouldn’t be writing this if IRR wasn’t a useful tool for making personal investment decisions!
For individuals, IRR can be used as a more robust version of ROI to find expected returns on something like a stock or better understand the risk on something like a real estate investment. The reason it isn’t used as often as ROI is that it’s extremely hard to calculate by hand, which makes the Kubera platform that we’re going to tell you more about later a worthwhile element of your portfolio management toolkit.
Real Estate Investments
As we touched on above, IRR is a helpful metric when it comes to making smart real estate investment decisions.
While real estate tends to grow in value over time, there are also a lot of ways in which cash flows in and out of these assets over their holding period. IRR considers this in its calculation, which can help investors better understand what the value of an asset may look like in the future and, therefore, how their returns will fare over time. For real estate investors, the asset with the highest IRR is typically the best choice.
Business Investments
It’s time to introduce you to the hurdle rate — which is the minimum acceptable rate of return a business wants to see before making an investment.
IRR is often used by businesses when capital budgeting to see if they should invest in a project. If that project won’t be able to generate an IRR that exceeds the hurdle rate, it’s likely a business won’t move forward with funding it. Additionally, they want to know the IRR will be higher than the average cost of capital as well as the payback rate of any loans taken out to support the investment.
Venture Capital Investments
Like businesses, venture capitalists usually also have some metrics they use to determine whether or not they want to inject capital into a new company. Typically, IRR is part of that suite of metrics as it’s a helpful way to measure if and when their investment will be returned.
4 Reasons Why You Should Calculate IRR for Investments
While IRR is a complex formula, there are some crucial reasons you should consider using it for future investment decisions.
Better Understand an Investment’s Risks
IRR isn’t just about figuring out which assets are worth your time and money, it can also help you see if potential money-threatening risks lie in the future of an investment.
How so? IRR identifies the future value of an investment and puts it in terms of today’s money. So while you may think an investment looks great based on ROI, IRR might uncover that over a certain amount of time and after a certain amount of cash flowing in and out, you’re at risk of actually losing money.
See How Cash Flow Will Impact Your Return
Speaking of cash flow, this is a consideration that not a lot of return-related metrics account for. And this fact makes it way too easy to view an asset with rose colored glasses and overestimate the return you’ll be able to generate.
But when a formula measures expenditures and cash injections, the way IRR does, you can get a much clearer idea of your real returns.
Going back to the real estate example, there is plenty of negative cash flow that come with holding a real estate asset — maintenance, mortgage payments, etc. But of course, there is also positive cash flow in the form of rental payments. With IRR, you can take all cash into account to understand the true value of an investment.
Holding Time Can Make All the Difference
Similar to cash flow, holding time is another really important consideration when it comes to figuring out what return to expect from an investment.
To mention ROI again, it’s a metric that doesn’t include the passage of time. So while an ROI of 30% might look amazing — if it takes 20 years to get there you might want to go looking for an asset that will increase in value faster. However, if you’re only calculating ROI, you’ll never be able to identify and compare the growth rate of different assets.
IRR adds holding time into the mix and also finds the annual rate of return you should expect — not the lifetime return. Because of this, It’s altogether a more reliable and easy-to-digest way to understand what kind of return you may actually generate.
Compare Investments on an Apples-to-Apples Basis
Because of the above elements — holding time, cash flow, etc. — the IRR formula eliminates outliers when finding the expected return for an asset. RR can even be used to compare returns on assets of all different types. This enables investors to conduct a true apples-to-apples comparison of assets and decide which is best for their situation.
One Big Reason *Not* to Calculate IRR for Investments: Complexity!
You knew there had to be at least one drawback, didn’t you?
Unfortunately, in the case of IRR, it’s a big one.
IRR is quite difficult to find manually.
This is because the discount rate (aka interest rate) that will bring the NPV in the equation to zero is unknown. Finding it is a major undertaking in trial and error.
To find IRR manually, one has to guess a discount rate, do the whole equation, and if the NPV isn’t zero, they would have to guess a new discount rate and do the whole thing over again. Wash, rinse, repeat until NPV finally arrives at zero.
This is why IRR has mostly fallen by the wayside for individual investors who don’t have the benefit of an accounting team to do this tedious and complex work for them.
However, today there’s an easy-to-use tool on the market that will make this calculation for you automatically — and it’s dang sure cheaper than hiring an accountant, much less a team of them.
Meet Kubera.
Automate IRR Calculation for all Your Investments with Kubera
Kubera is personal balance sheet software that we custom built to automatically connect to more bank, brokerage, crypto, NFT, and other accounts (see some of ‘em here!) than any other wealth tracker on the market. And our spreadsheet-like interface also makes it easy to track assets that aren’t traditionally associated with accounts — antiques, collectibles, real metals, etc.
But we’ll cut straight to what you want to know: how Kubera can help you understand IRR for all your different asset types.
With Kubera, all you have to do is make sure a few key pieces of information about an asset are up to date, namely the purchase price, the current value, and cash flow. After adding holding time to the equation, Kubera will automatically display your ROI — in your preferred currency.
This is a big deal for assets purchased using cryptocurrency. Why? Because only seeing the value of an asset in crypto makes it pretty difficult to compare its returns to the other assets and accounts you have that are all measured in your preferred Fiat currency.
By converting IRR into your preferred currency, Kubera gives you an opportunity to better understand asset value and returns using currency you “think in” and use every day.
Another way Kubera makes it easier to compare the value of your assets is by also displaying the performance of a few popular indices and cryptocurrencies. By looking at the performance of say Tesla or the Dow, you’ll have a frame of reference for whether or not your asset returns are where you want them to be.
See Kubera’s IRR calculator in action when you check out our IRR help center article.
In addition to Kubera’s clean portfolio tracker interface, we integrate with asset experts like Zillow and EstiBot to give you the real-time value of web domains, vehicles, and real estate assets.
Then, our beautiful charts and recap feature combine tons of data to give you a summary of how your portfolio and assets are performing daily, weekly, monthly, quarterly, and yearly.
Kubera offers a paid subscription, meaning we don’t need to monetize your data or annoy you with ads or upsells — just another element that puts us on the cutting edge when it comes to modern personal balance sheet software.
Work with a financial advisor, wealth manager, or another financial pro? You might be able to use Kubera for free! Just have them request a demo today to see how our white-label platform can help them better serve more tech-savvy consumers like yourself.
