Insights

1 Great Profitability Metric for Investors

The internal rate of return (IRR) is a useful tool for investors when looking at companies’ investment projects. –

The Internal Rate of Return (IRR) calculates the return rate at which the present value of future cash flows is equal to the initial investment.

This means the IRR indicates the minimum rate of interest required to break-even on the initial investment.

While IRR is not typically used by retail investors to determine a stock price, it can come in handy if an investor wants to analyse a potential acquisition or project being undertaken by one of their portfolio companies.

This allows them to assess if the new endeavour will be earnings-accretive to the company.

Let us take a quick look at the IRR formula. It is calculated by equating the sum of the present value of future cash flow less the initial investment to zero. 

Cashflow Year1/(1+IRR)1 + Cashflow Year2/(1+IRR)2 +…..+ Cashflow YearN/(1+IRR)n – initial Investment = 0

The formula requires two pieces of information – capital required to start the project and a reasonable estimate of the future periodical income of the investment. This then allows the calculation of the IRR.

There are three main assumptions when using the IRR methodology:

  1. The investments made by the investor will be held until the end of its maturity.
  2. The intermediate cash flows earned will be reinvested at the internal rate of return itself.
  3. The time gaps between different cash flows of the investment are equal and periodical.

Let’s look at an example. Assume portfolio Company X is planning to invest $100,000 into a new project. It estimates that it can generate $30,000 per year from this investment for the next 5 years.

Using the IRR formula, the IRR generated by this investment would by approximately 15.2%. The investor can then compare the rate of return to the return generated by the company before this investment.

If the IRR is higher than its current returns it means this is a prudent investment. However, if the IRR is lower than the companies’ current returns, it means the investor might want to re-evaluate the investment thesis.

Foolish conclusion

The internal rate of return can be used by investors to evaluate if new projects/acquisitions taken on by a company are attractive compared to the company’s current returns.

An investment with a substantially higher IRR value would thus allow the company to enjoy stronger growth going forward.

More reading

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. 

The Motley Fool Hong Kong Limited(www.fool.hk) 2020

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