IRR vs. AAR? They're Better Together

It takes several metrics to tell an investment's complete story. Let's discuss the story these two tell together.

Many investors have their favorite metric they look for when considering an investment. At Capital Velocity Investments, we believe that it takes several different metrics to really explain the risk and reward profiles of a given investment. We like to supply as many pieces of the puzzle as possible, so investors can make the most informed decisions. So, today, let’s look at some sample numbers to demonstrate how these metrics relate to each other.

For reference, IRR stands for “Internal Rate of Return,” and AAR stands for “Average Annual Return.”

It all starts with “total return.”

Total return gives the big picture of what an investment hopes to return on the initial investment. Let’s say an investment aims to return 100%, meaning if you invested $10,000, you would receive a total of $20,000 back at the end of the investment. Now, this could be a good or bad investment, depending on how long it took to earn that return.

Generally speaking, every investment metric calculation starts with the total return and then adds one or more other variables like time or cash flow. We can look at the projected returns and make better decisions if we understand how they’re calculated and their potential vulnerabilities.

AAR = Total return divided by number of years.

In the scenario above, we have an investment that returns 100%. If that return is projected to take 5 years, then it may be a great investment, returning 20% AAR (100%/5 = 20%). If it takes 10 years, however, to earn that 100%, then our returns are are not near as attractive, only projecting 10% AAR.

This again may or may not be a good investment, depending on how much, if any, of that return pays out in each of the 5 years. For example, the AAR can be 20% even if the investment doesn’t pay out a single dime until the lump sum of $20,000 is delivered at the end of year 5. That’s why we use multiple metrics, because if all of the $20,000 comes out in year 5, then we lose the ability to reinvest in other opportunities during the life of this investment. It still may meet our goals, but we need to know more.

IRR: How quickly can we compound our investment?

IRR is a measure of cash flows/returns over time, generally calculated by year. The calculation adds an element that AAR doesn’t measure. Using the example above, the IRR tells us how quickly we will receive how much of that $20,000. If it takes until the end of year 5, our IRR and AAR are the same. But let’s say that the investment pays us $4,000 each year for the 5 years; now our IRR is 29% because of the rate the money returns to the investor. This measurement takes into account in investor’s ability to invest that money as it comes back to us. We’re still getting a total of $20,000 (5 x $4,000), but our compounding potential is much higher.

(The actual calculation for IRR is an iterative limit function approaching zero, so if you want to brush up on some basic calculus, you can Google it. We prefer to let Excel take care of it.)

For most seasoned investors like me, the quicker money comes back and is available for reinvestment, the better the investment. I talk about creating an investment snowball a lot, and high IRR investments are key to “snowballing” wealth quickly.

Conclusion

The bottom line is that when deciding if an investment is right for you, you need to get as clear a picture as possible about the amount and the timeline an investment projects to return. If the total return projected is enticingly high and you can keep building toward your goals without that money, IRR might not be the most crucial metric; total return and AAR might drive your decision. But, if you have plans for future investments that require some of this money, IRR becomes much more important.

Other metrics we like that we’re not discussing today include “cash-on cash” and “equity multiple.” Taking them all together as part of a complete picture made from individual snapshots tells the story of the investment, and whether or not it fits your journey toward your goals.

-Matthias