XIRR vs CAGR: Understanding the Key Differences

Investing in the stock market or mutual funds requires evaluating returns accurately. Two popular metrics used to measure returns over time are XIRR (Extended Internal Rate of Return) and CAGR (Compound Annual Growth Rate). While both help investors measure returns, they serve different purposes. Let’s explore the key differences between XIRR and CAGR, use cases, examples, formulae, and limitations of XIRR and CAGR.

What is XIRR (Extended Internal Rate of Return)?

XIRR, or Extended Internal Rate of Return, is a more flexible way to calculate returns, especially when there are multiple cash flows at different time intervals. It is widely used for investments with regular/irregular and multiple contributions, such as SIPs (Systematic Investment Plans), real estate investments, or business cash flows. 

Unlike CAGR, which assumes a single investment, XIRR considers each investment and withdrawal separately, making it a more accurate representation of real-world scenarios.

XIRR considers each cash inflow and outflow along with the time of the transactions, making it more accurate. This method is particularly useful for investors who make periodic investments, such as monthly SIPs, or those who withdraw funds at different intervals, ensuring that the return calculation reflects the actual performance of the investment.

Formula for XIRR

XIRR is calculated using an iterative method that solves for the rate (r) in the equation:

Where:

• Ct = Cash flow at time t

• r = Rate of return (XIRR)

• t = Time period in years

• NPV = Net Present Value of Cash

Since XIRR is not straightforward to compute manually, it is usually calculated using Excel’s XIRR function or financial calculators.

Calculation of XIRR using Excel 

Let’s assume Rajesh decides to start an SIP of Rs 5000 per month in a mutual fund for a period of 12 months and at the end of the year, his fund value stands at Rs 62000. Since the contributions were made over different periods, the calculation of the Rate of Return needs to be made using the XIRR function in Excel. The table below will help you understand better.

To calculate XIRR in Excel, use the formula XIRR(values, dates, Guess). Input the column values for investment figures and the dates in the formula. Excel gives the value of XIRR, which in this case is 6.18%.
Remember to input all outflows (amount invested) in negative and the value at the end of the term or withdrawals as a positive figure.

What is CAGR (Compound Annual Growth Rate)?

CAGR is a standardised way to measure the annualised return of an investment over a specified period. It assumes that returns are compounded annually and helps investors understand the average growth rate of an investment. It is widely used to evaluate the performance of lump sum/one-time investments such as stocks, mutual funds, and fixed deposits over a long period.

CAGR is particularly useful for comparing different investment options, as it provides a smooth growth rate over time, ignoring short-term fluctuations. However, it does not consider multiple cash flows or the impact of investment timing, making it less accurate for investments involving multiple contributions or withdrawals.

The formula for CAGR:

Where:

• Ending Value = Final investment value

• Beginning Value = Initial investment value

• n = Number of years

CAGR is commonly used for lump sum investments where there are no additional cash inflows or outflows.

Differences Between XIRR and CAGR

The table below highlights the key differences between XIRR and CAGR.

When to Use CAGR vs XIRR?

Use CAGR when:

• You are analyzing a lump sum investment (e.g., a stock purchased and held for five years).

• You want a simple, straightforward way to compare investment performances.

• You assume no additional cash flows during the investment period.

Use XIRR when:

• You have multiple cash flows (e.g., SIP investments, and staggered stock purchases).

• You need to consider the timing and frequency of investments and withdrawals.

• You want a more accurate measure of actual returns over a period.

Examples of CAGR and XIRR

• Example of CAGR

Imagine you invested ₹1,00,000 in a mutual fund, and after five years, the value grew to ₹1,80,000. The CAGR would be calculated as:

= (Final value / Beginning value) ^1/n - 1

 = (180000/100000)^(⅕) -1 = 12.47%

• Example of XIRR

Suppose you invest ₹10,000 every year for five years in an SIP, and at the end of the fifth year, the total investment value is ₹65,000. Since cash flows occur at different intervals, XIRR will consider each contribution’s timing, leading to a more accurate return than CAGR.

Using Excel’s XIRR function with specific dates for each investment will yield a result of 8.8%.

Limitations of CAGR and XIRR

CAGR Limitations:

• It ignores interim cash flows, making it unsuitable for SIPs or staggered investments.

• It assumes a steady rate of return, which is not always realistic in volatile markets.

• It does not account for market fluctuations or investment timing.

XIRR Limitations:

• It is more complex to calculate and requires software like Excel.

• If cash flows are highly irregular, XIRR calculations may vary significantly.

• For short-term investments, XIRR can sometimes produce misleadingly high or low results.

Conclusion

Both XIRR and CAGR have their uses in evaluating investment performance. While CAGR is ideal for lump sum investments, XIRR provides a more accurate picture when multiple cash flows are involved. Understanding the differences between these metrics will help you make more informed investment decisions.