Internal rate of return (IRR) is the expected average return of an investment. IRR is commonly used in corporate finance and is similar to the compound annual growth rate (CAGR), which is more commonly used by stock investors.
IRR is a part of the net present value (NPV) equation. A project's IRR is the return rate that makes the net present value of the project equal $0.
How to calculate IRR
Using a program like Microsoft (NASDAQ:MSFT) Excel is the most efficient way to calculate IRR. Perhaps counterintuitively, to compute an IRR, first we need the formula for NPV:
Limitations of IRRWhile IRR is useful for financial professionals, it only considers cash flows. IRR calculations don't take into consideration the accuracy of the cash flow projections or other risks related to the proposed project.
A famous investor once said that a project's NPV is like the Hubble Telescope -- adjusting your position by an inch can land you in a totally different universe. IRR has essentially the same limitations.
IRR vs. return on investment (ROI)
While IRR is used primarily by companies to make business decisions, return on investment (ROI) is used by stock investors to determine investment gains on a percentage basis.
If you buy a stock for $50 and later sell it for $75, your ROI for that investment is the amount of the stock price increase divided by the amount that you paid for the stock and multiplied by 100 to express the return as a percent. The stock price increase of $25 in this example would represent an ROI of 50%.While IRR takes into account the passage of time, ROI does not. A stock's ROI can remain the same regardless of how much time passes between purchase and sale.