Rate of Return: Beyond the Basics
When discussing investments, Rate of Return often comes up. Do you know what it is? And how to calculate it? We’ll start with the basic concept of internal rate of return and then discuss external rate of return.
So what is Internal Rate of Return?
IRR is a micro-economic calculation used to determine the growth or loss of an investment over a period of time by determining how much money was invested, at what intervals, over how much time, to produce a certain return.
Simple example: if you invested $10 for one year, and at the end of the year, you got back your original $10 plus another $1, then you have achieved a 10% internal rate of return.
This was easy to calculate. But if I ask you to calculate the internal rate of return that will be achieved in an investment where you will invest $10 today, $15 three years from now, where you will receive annual payments of $10 for four consecutive years starting in five years, now what’s the answer? That’s a bit more complicated. There are formulas to figure this out with a pen and paper, but I’ve forgotten them since business school, and it’s pretty unnecessary today since business calculators can easily do this for you.
Internal Rate or Return is important both as a calculation to look back and see how a past investment has performed, and as a predictive analytic tool to determine if a potential investment is suitable. Your expected return should more than compensate for the risk you are taking on. This shouldn’t be the only reason you invest, but that is a subject for a later discussion.
So what is External Rate of Return?
ERR is a macro-economic measurement that looks at the overall impact of a financial move on your entire financial life. It involves the “big picture.’ Anytime you decide to put money somewhere, you’ve also made the decision not to put it anywhere else. Both decisions have ripple effects throughout your entire financial life. This is more difficult to calculate and takes a more broad level of thinking and is therefore ignored by most people (including financial professionals).
Perhaps it’s easiest to give an example. Let’s say that a McDonald’s franchise hires you as a consultant to help them increase their profitability. As you begin to look into their financial performance, you begin to notice that they make almost nothing selling burgers. You also notice that they make a tremendous profit selling fries and soft drinks. You immediately calculate how much money goes into the cost of the burgers and realize that they have little to no internal rate of return on these burgers, but that the internal rate of return on the fries and drinks is incredible!
Would you then go to the owner and tell him that he immediately needs to stop selling burgers and focus on selling fries and drinks so that he can increase profits? Of course not! That would be foolish. People come to McDonald’s in droves for their burgers, and once they’re there, they buy fries and drinks. If they stopped selling burgers, most people would stop coming. The burgers might not have an internal rate or return, but their external rate of return is enormous. Every financial decision has ripple effects throughout your financial world and they must all be considered before determining the true value of any financial decision.
Let’s look at another decision. Let’s say you have a small business and basically act as a traveling salesman. You must be on the road all the time going from customer to customer making sales and while you are traveling, you make calls on your cell phone to set up tomorrow’s meetings. When you sit down at the end of the year to plan your budget, if you followed the type of thinking that is all too often prevalent in most people’s financial decions, you might decide to cut out your cell phone bill because you send them $100 every month and you never receive anything back for it. It has absolutely zero internal rate of return. Yet, I think by now, you understand that the external rate of return of having this cell phone is huge because you use it to set up all your meetings where your sales are made.
When making financial decisions in your own areas of stewardship, it’s important to always think about not only what you expect to happen within the confines of the investment you are looking at (IRR), but also to look at what the consequences of this decision will be versus others you could make (ERR).
Photo credit: K e v i n