Inside the IRR

IRR (Internal rate of return) indicates the comparative profitability of a possible investment by taking into account all outgoing and incoming cash flows from an investment over the investment period. 

IRR is one of the most common metrics by which investors judge funds. So naturally your hosts on ‘A Dictionary of Finance’ podcast, Matt and Allar, wanted to find out what exactly it tells you, how its calculated—and how to pronounce it.

We invited Aglaé Touchard-Le Drian and Gunter Fischer, investment officers with the European Investment Bank’s Global Energy Efficiency and Renewable Energy Fund, to explain it. We quickly realized that without pen and paper, and several years of post-graduate studies, we wouldn’t really be able to fully get it.

But we did find out some useful facts about IRR:

• you should check the fine print when reading about a fund’s IRR, because it does depend on various assumptions and valuations
• higher IRR is in general better than lower IRR (this is the point in the show where our guests collectively, and almost audibly, went: “Duh!”)
• IRR is also situational. Meaning that a 6% IRR for a wind energy project in Belgium might be great, but for a similar project in sub-Saharan Africa investors wouldn’t really bother. The return has to match the risk.

We also hear about the difference between realized and targeted IRR, and dabble a little with the concept of present value of future cash-flows.

And why is it “internal”? It’s because the rate really depends on cash-flows inside a firm or fund.

But this internal rate of return is really used by investors externally – to compare that fund’s performance with possible other investments they could make, or could have made.

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