XIRR vs CAGR: Understanding the Crucial Difference and When to Use Each Metric

XIRR and CAGR are two common metrics typically used in the evaluation of investment returns. They are shown in the extended internal rate of return(XIRR) and the compound annual growth rate (CAGR). As much as each is usable for an investment's return gain assessment, there are the two measure tools that serve different purposes and are applicable in different scenarios.

This blog essay reveals the differences between XIRR and CAGR, their acronyms, the step-by-step process of computing them, as well as the usage of each metrics for a well-grounded investment decision.

What is CAGR in the Share Market?

CAGR means Compound Annual Growth Rate and it represents the smoothed annualized return of the investment over a certain period in which it is supposed that the investment is going up at the same steady rate every year.

CAGR Formula

CAGR = (FV / PV)^1/n - 1

Where,

• FV = Final Value of the Investment

• PV = Initial Investment (Present Value)

• n = Number of years

When to Use CAGR?

• When analyzing the long-term growth of a single investment.

• If there are no intermittent cash flows (e.g., lump sum investments).

• To compare different investment options with fixed growth rates.

Limitations of CAGR

• It assumes a constant growth rate, which is rarely the case in real-world investments.

• It does not account for multiple investments or withdrawals over time.

What is XIRR Return?

XIRR means Extended Internal Rate of Return. It’s a step up from the regular Internal Rate of Return (IRR). XIRR deals with cash flows that come in at different times and amounts.

Unlike CAGR, which assumes a steady return, XIRR looks at when you get each cash flow and how much it is.

XIRR Formula (Simplified Explanation)

XIRR solves for the discount rate (r) in the equation:

NPV = C / (1 + r)^t

• C = Cash flow at time t

• r = XIRR (rate of return)

• t = Time period of cash flow

Since this formula requires iterative calculations, it is best solved using Excel or financial calculators.

When to Use XIRR?

• When investments involve multiple transactions over time (SIPs, withdrawals, dividends).

• When calculating returns for mutual funds, systematic investment plans (SIPs), or real estate investments.

• If cash inflows and outflows happen at irregular intervals.

Limitations of XIRR

• It assumes that all cash flows are reinvested at the calculated rate, which may not always be realistic.

• It can be difficult to interpret if there are multiple rate-of-return solutions.

XIRR vs CAGR: Key Differences

CAGR VS XIRR: Which One Should You Use?

CAGR (Compound Annual Growth Rate): The Simple Return

Used for: Single investments with a fixed starting and ending value. Think of it like a lump-sum deposit in a fixed deposit or a one-time purchase of a stock.

Example: You invest ₹10,000 in a fixed deposit for 3 years at 6% interest.

Ending value: ₹10,000 * (1 + 0.06)^3 = ₹11,910.16

CAGR: (₹11,910.16 / ₹10,000)^(1/3) - 1 = 0.06 or 6%.

Interpretation: Your investment grew at an average annual rate of 6% over those 3 years.

XIRR (Extended Internal Rate of Return): The Multi-Flow Master

• Used for: : Investments with multiple cash flows, meaning you add money or withdraw money at different points in time. This is common in SIPs, real estate, or even a business where you make investments and receive profits over time.

• Example: You start an SIP in a mutual fund with these contributions:

  • Month 1: ₹5,000

  • Month 3: ₹3,000

  • Month 6: ₹4,000

  • Month 9: ₹2,000

  • Month 12: ₹1,000

• You redeem the entire investment after 12 months for ₹18,000.

• You would need a financial calculator or spreadsheet software to calculate the XIRR, which would be the annualized return considering all the inflows and outflows.

In a nutshell:

CAGR is good for single investments with a clear beginning and end.

XIRR is essential for investments where you have multiple deposits or withdrawals, making it more realistic for most investment scenarios.

Conclusion

XIRR and CAGR are both important ways to measure investment returns, but they are different. CAGR is great for long-term steady growth. XIRR, on the other hand, shows a clearer picture when you have investments with changing cash flows.