by Siddharth Singh Bhaisora
Published On June 9, 2024
Investing today is more complex than ever, requiring not just knowledge of financial instruments but also the ability to evaluate their performance effectively. While many metrics are available to assess investment growth, one particularly useful metric is the Compound Annual Growth Rate (CAGR). However, when it comes to evaluating smallcases , which involve periodic investments, XIRR (Extended Internal Rate of Return) often provides a more accurate picture.
CAGR is effective for single, lump-sum investments made at the beginning of a period. However, smallcases often involve periodic investments, such as monthly contributions, which CAGR cannot accurately account for. XIRR, on the other hand, is designed to handle multiple cash flows, considering both the timing and amount of each investment. This results in a more precise annualized rate of return.
The time value of money is a fundamental principle stating that money today is worth more than the same amount in the future due to its earning potential. XIRR incorporates this concept, recognizing the varying growth potential of each cash flow over time. This ensures that the returns calculation reflects the real growth or depreciation of your investments.
Feature | XIRR (Extended Internal Rate of Return) | CAGR (Compound Annual Growth Rate) |
Definition | Calculates the annualized rate of return for a series of cash flows occurring at irregular intervals | Calculates the annualized rate of return assuming a single initial investment and a single ending value over a period |
Cash Flow Consideration | Considers multiple cash flows at different times (both inflows and outflows) | Considers only the initial and final investment values without accounting for intermediate cash flows |
Time Value of Money | Fully incorporates the time value of money, adjusting for the timing of each cash flow | Considers the time value of money only between the start and end dates |
Use Case | Best for evaluating investments with multiple contributions and withdrawals (e.g., SIPs, periodic investments) | Best for evaluating single, lump-sum investments over a period |
Complexity | More complex to calculate; often requires financial software or tools like Excel | Simpler to calculate manually or with basic tools |
Accuracy in Periodic Investments | Provides a more accurate measure of returns for investments with irregular cash flows | May give a misleading picture for investments with multiple or irregular cash flows |
Standardized Measure | Not standardized, as it depends on the specific cash flows and their timings | Standardized measure of growth, providing a consistent annual growth rate |
Comparative Analysis | More effective for comparing investments with different cash flow patterns | Effective for comparing single investment growth rates over similar time periods |
Consider an investor who started with a ₹2 lakh investment in a Dividend – Smart Beta smallcase in July 2018, followed by monthly contributions of ₹20,000 until June 2023. Over these 61 months, the total investment would be ₹13,80,000, growing to ₹19,40,444. Calculating the absolute returns gives a 41% return, but this doesn't consider the timing of each ₹20,000 SIP. CAGR can't be used here due to the varying cash flows. Instead, XIRR, which accounts for all these investments and their timing, provides a more accurate return rate of 12.1%.
Metric | Value |
Initial Investment (₹) | 2,00,000 |
Total SIPs (₹) | 11,80,000 |
Ending Value (₹) | 19,40,444 |
Absolute Returns (%) | 41% |
CAGR (%) | Not Applicable |
XIRR (%) | 12.1% |
Calculating XIRR manually involves iterating to find the discount rate that sets the Net Present Value (NPV) of cash flows to zero. Here's a step-by-step guide on how you can do this manually, though it's typically more practical to use financial software or a calculator due to the complexity of the calculations.
Record each cash flow (investment or withdrawal) and its corresponding date.
Cash flows are typically negative for investments (outflows) and positive for withdrawals (inflows).
Calculate the time difference in years between each cash flow date and the first cash flow date. This can be done using the formula:
Choose an initial guess for the rate of return (let's call it ‘r’).
Calculate the NPV of the cash flows using the chosen ‘r’. The formula for NPV is:
Where:
Ci = Cash flow at time i
ti = Year fraction at time i
r = Estimated rate of return
Adjust ‘r’ and recalculate the NPV until the NPV is as close to zero as possible. This iterative process can be done using methods like Newton-Raphson, but it's more practical to use a financial calculator, excel or software for this step due to its complexity.
Let's illustrate with a simplified example:
Initial Investment: -₹200,000 on 01/07/2018
Monthly Investments: -₹20,000 on the first of each subsequent month until 01/06/2023
Ending Value: ₹19,40,444 on 01/06/2023
Date | Cash Flow (₹) |
01/07/2018 | -200,000 |
01/08/2018 | -20,000 |
... | ... |
01/06/2023 | -20,000 |
01/06/2023 | 19,40,444 |
Date | Cash Flow (₹) | Year Fraction |
01/07/2018 | -200,000 | 0.00 |
01/08/2018 | -20,000 | 0.08 |
... | ... | ... |
01/06/2023 | -20,000 | 4.92 |
01/06/2023 | 19,40,444 | 4.92 |
Let's start with an initial guess of ‘r’= 10% or 0.10.
Using the NPV formula:
Perform this calculation for each cash flow. If the NPV is not close to zero, adjust ‘r’ and repeat.
Adjust r incrementally and recalculate the NPV until it approaches zero. This iterative process can be cumbersome and is why tools like Excel's XIRR function or financial calculators are commonly used.
In Excel, you can use the XIRR function to simplify this process:
List your cash flows in one column.
List the corresponding dates in another column.
Use the formula = XIRR (cash_flows, dates) to calculate the XIRR directly.
Create a column for cash flows and enter all cash flows (negative for investments, positive for withdrawals).
Create a corresponding column for the dates of each cash flow.
In a new cell, use the XIRR function to calculate the XIRR = XIRR(cash_flows, dates). Replace cash_flows with the range of cells containing the cash flow values and dates with the range of cells containing the corresponding dates.
A1: Date | B1: Cash Flow
A2: 01/07/2018 | B2: -200000
A3: 01/08/2018 | B3: -20000
...
A63: 01/06/2023| B63: -20000
A64: 01/06/2023| B64: 1940444
C1: =XIRR(B2:B64, A2:A64)
Result in C1 will be the XIRR.
Initial Investment Date: A2 (e.g., 01/07/2018)
Initial Investment Value: B2 (e.g., -200000)
Ending Value Date: A64 (e.g., 01/06/2023)
Ending Value: B64 (e.g., 1940444)
Number of Years: =(A64 - A2)/365 in a separate cell, say C1.
CAGR Calculation: =(B64 / B2)^(1/C1) - 1
Ensure that all cash flow entries are correctly signed (negative for outflows and positive for inflows).
Dates should be in Excel date format.
Use the formula auditing tools in Excel to ensure the ranges and calculations are correct.
While CAGR is useful for evaluating single, lump-sum investments, XIRR is essential for a comprehensive analysis of periodic investments like those in smallcases. By incorporating the time value of money and recognizing the impact of each cash flow, XIRR provides a clearer, more accurate picture of investment performance. For investors looking to evaluate their smallcase portfolios, tracking XIRR is the superior method to understand real returns and make informed investment decisions.
Read these comprehensive Smallcase How To Guides to understand all you need to know about Smallcases:
Should You Invest In Smallcases? Are Smallcases a Good Investment?
Understanding the Importance of Rebalancing Your Smallcase Investments
Understanding Smallcase Returns, Lock-In Periods, and Minimum Investments
Why Use XIRR Instead of CAGR To Evaluate Your Smallcases Performance
How to Partially Exit or Sell Individual Stocks in Smallcases
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