Internal rate of return, abbreviated IRR, is a calculation often used to compare investments such as real estate and insurance policies. In simple terms, the IRR defines the growth of your investment as a percentage. The number is calculated from the value of the investment at the end of a time period, as opposed to the initial capital and any payments made during the period. Often IRR is calculated on a one-month term, and must be extrapolated into an annualized return for accounting purposes. Multiplying by 12 gives an approximate figure, but accurate calculations use a more complex equation.
Add 1 to your monthly IRR. For example, if your monthly rate of return is six percent, you would add 1 to 0.006 for a total of 1.006.
Raise that total to the 12th power. In this instance, that would give a figure of 1.0744.
Subtract 1 from the total. In our example, that leaves 0.0744. Expressed as a percentage, that works out to an annualized IRR of 7.4 percent.
Internal Rate of Return is useful for comparing investments, but it is only one of several analyses that should be considered before making a decision. It doesn't take into account real-world considerations such as taxation and differing degrees of risk between investments.
Modern spreadsheet programs include Internal Rate of Return among their functions, which can be more practical doing each calculation manually from scratch.
- Society of Petroleum Evaluation Engineers: SPEE Recommended Evaluation Practice #10 – Calculating Internal Rate of Return
- Property-Investing.org: Annualize Monthly Returns
- Fat Pitch Financials: How to Calculate Your Return on Investment
- National Real Estate Investor: IRR Miscalculations Waste Time and Money