The objective of any investment is to generate returns, and while calculating the returns, investors come across terms like compounded annual growth rate (CAGR) and extended internal rate of return (XIRR).
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Both of these are used to gauge the effectiveness of the investments. Although some investors confuse these metrics and use them interchangeably, they are different. We will try to understand both these metrics and highlight the differences between them
What is CAGR?
As the name suggests, compounded annual growth rate or CAGR calculates the average annual return of any investment, assuming returns are compounded every year. This is ideal for calculating the return when an investment is made once.
Is CAGR the same as Absolute Returns?
CAGR is different from absolute returns. The absolute return shows the total return from the day the investment was made till the date when you are calculating it. CAGR, on the other hand, shows average annualised returns.
The formula for CAGR is
CAGR = (Ending Value/Beginning Value)^ (1 / Number of Years) – 1
Example:
If you invest ₹1,00,000 in a mutual fund. After five years, the investment grows to ₹1,50,000. What is the annualized return (CAGR)?
(Ending Value/Beginning Value)^ (1 / Number of Years) – 1
CAGR = (150000/100000) ^ (1/5) – 1
CAGR = 8.45% per annum
What is XIRR?
Just like CAGR, XIRR is also used for measuring returns, but XIRR helps us to calculate returns on investments made at different intervals like SIP.
Although there is no algebraic formula for XIRR, it can be calculated using the XIRR function in Excel or Google Sheets, where the formula is
XIRR = (value, dates, guess)
Example:
If you invest ₹5000 each month in a mutual fund for 6 months. Your portfolio value is ₹32,000. What is the XIRR?
Here is the calculation for XIRR using excel
| Date | Amount |
| 01-01-2024 | -5000 |
| 02-01-2024 | -5000 |
| 03-01-2024 | -5000 |
| 04-01-2024 | -5000 |
| 05-01-2024 | -5000 |
| 06-01-2024 | -5000 |
| 07-01-2024 | 32000 |
|
24.63% |
|
Difference between XIRR and CAGR
| CAGR | XIRR | |
| Meaning | Helps in calculating point-to-point return by considering initial investment and final value | Helps in tracking returns on investment made at frequent intervals |
| Suitable for | Best suited for lump-sum investments | Best suited for investments with multiple inflows like SIP |
| Timing | Assumes single investment at the beginning | Considers exact timing of the investments |
| Investment type | Lumpsums or any other one-time investment | SIPs and other regular investments |
When to Use CAGR and XIRR?
Use CAGR for:
- A one-time investment.
- Calculating the average annual growth rate.
- Comparing returns of various investments.
Use XIRR for:
- Help us to measure the average annual growth of investments that are done multiple times in the same product, like SIP or additional lump-sum investments.
- Measuring the exact returns on investment
Parting Thoughts
Both CAGR and XIRR are crucial metrics for measuring the returns of your investments, but they serve different purposes. CAGR is ideal for single, point-to-point investments, while XIRR is best for multiple investments.
