When cash flows are ‘well-behaved’, then the IRR makes more or less sense, because you can argue that it is equivalent to the yield (interest rate) that a bond would pay to bondholders, and the cash flows are the (variable) coupons that you receive, and the Face Value of the bond is the cash flow you receive in the last year (at ‘exit’). Phew!
Let us take a look. In the ideal world, your cash flow stream might look like that, and the IRR is 15% in this case. In the last year, we have simply assumed that the business is sold at 5 times the cash flow generated in the previous year.
In a previous article (‘Stop using the IRR!‘), we explained why the Internal Rate of Return is a completely misleading and useless measure of finance performance; and recommended to use the ROE (Return on Equity), the ROIC (Return on Invested Capital), as well as the peak funding requirement, the payback period and the NPV (Net Present Value).
There is another die hard in business: the P/E ratio for a company listed on the stock market. This is the ratio of the share price to its earnings after tax.
The average P/E ratio of US equities was 14 in the 20th century, and roughly the same in other countries.
So now, this is how the story goes in the media: “P/E ratio lower than 10 – BUY! The stock is a bargain!”. Or “P/E ratio higher than 20 – SELL! The stock is expensive”.
It’s funny that the IRR – the Internal Rate of Return – is still in use with finance professionals. Actually it is not funny, it is sad, especially when you consider the many flaws that the IRR has. But it is human after all: the IRR looks like a wonderfully simple selection criteria. If a project delivers 15% IRR and my cost of capital is only 10%, then I should invest in this project! And if another project delivers 20% IRR, then I should invest in that one instead! Unfortunately, things are not that simple.
But what is the IRR? It is really hard to find anyone who can explain it in terms that make sense. No surprise there: the IRR is a mathematically defined percentage and most people hate mathematics. By the way: do you know that the IRR is so fuzzy that it can only be calculated by computers (and Excel) using iterative methods i.e. you can simply calculate IRR as a simple sum or ratio of other things. Unlike your beloved NPV, ROIC and the likes.