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What is IRR?
Let’s use a simple analogy to explain IRR and NPV and how they work together. Think of it like filling a water bucket with money.
IRR is the rate at which the water flows into the bucket, so that it fills the bucket perfectly to the top—no spills, no shortfalls.
Think of IRR as a magic rate that makes all the water sources work together to fill the bucket exactly to its brim (NPV = 0). It adjusts the speed and volume of water from each source (cash flow), so you fill the bucket exactly.
IRR finds the rate at which all the future water (cash flows) add up to the exact amount you need to fill the bucket without any extra or missing.
Example:
If your IRR is 21.8%, it means the water is flowing fast enough that all future cash flows, when added together, will perfectly fill your $4 million bucket over 3 years.
If the IRR is lower, say 10%, then the water is flowing slower, and it might take longer, or the bucket may not be filled.
Using The Water Bucket Investment Analogy
You have a bucket that represents your initial investment.
Let’s say your bucket holds $1,000. That’s the amount you’re investing today in a project (real estate or the stock market).
The water (cash flows) you pour into the bucket is your future returns.
Over time, you expect water (cash) to come from different places, like rental income or stock dividends. At the end, there’s also water from the sale of the property or the final value of your stock.
What is Net Present Value (NPV)?
NPV tells you how much water you’ll end up with today if you take all the future water and pour it into the bucket at once, but discount some of it based on how far into the future it is.
Think of NPV like filling up your bucket in stages:
If you get water (cash flow) today, you pour it in directly, filling your bucket without any loss.
If you get water next year, you’re further away from the bucket, so some spills as you pour it in. The farther away the water source (the cash flow), the more you lose on the way in.
The discount rate determines how much water you lose as you pour from far away (future cash flows). A higher discount rate means you lose more water.
So, NPV calculates the total amount of water (cash) you can pour into the bucket today, even though the water is coming from different sources and times.
If the NPV is positive, the water from the future is more than enough to fill the bucket, meaning the investment is profitable.
If the NPV is zero, it means you filled the bucket exactly to the top—just enough return to break even.
If the NPV is negative, there’s not enough water, meaning the investment might lose money.
The Time Value of Money
We discount future earnings to today’s value because of the concept of the time value of money. In simple terms, money today is worth more than money in the future – with the caveat the money is invested wisely rather than spent foolishly. Here’s more:
Opportunity Cost:
Money you have today can be invested to earn returns. If you have $1,000 today, you could invest it and potentially earn interest or returns over time. For example, investing $1,000 at 10% will give you $1,100 in a year.
By contrast, if you’re promised $1,000 a year from now, it’s not as valuable because you miss the opportunity to invest it today and earn returns.
Inflation:
Inflation reduces the purchasing power of money over time. $1,000 today might buy more goods and services than $1,000 will in the future because prices tend to rise over time.
Risk and Uncertainty:
Money that’s promised to you in the future comes with more risk. There’s a chance you might not receive it due to unforeseen events, such as default or market changes.
By discounting future earnings, we account for this risk, recognizing that the further into the future cash flows are, the less certain they become.
Investor Preferences:
Most investors prefer to receive money sooner rather than later. This preference makes future cash flows less valuable when compared to the same amount of money received today.
The Key Formula (Net Present Value - NPV):
By discounting future cash flows, we can calculate their present value (what they’re worth today). We use a discount rate (often based on expected return or opportunity cost) to convert future cash flows into today’s dollars. This helps us compare different investments that might have uneven cash flows or different time horizons.
In summary, discounting future earnings gives us a more accurate picture of what those future amounts are worth today, allowing for better investment decision-making.
Concepts Summary:
NPV: The total amount of water (cash) you’ll have today, after considering that water flows from different places and times.
Positive NPV: You’re filling the bucket and have extra water.
Zero NPV: You fill the bucket exactly—just break even.
Negative NPV: You don’t have enough water—you’ll lose money.
IRR: The rate at which water flows into the bucket so that by the end, your bucket is perfectly full—no extra, no shortfall.
Time Value of Money: money today is worth more than money in the future.
Stay Tuned for part 2 of this 7-part series on IRR
Now that we’ve introduced the bucket analogy to explain how IRR and NPV work, the next step is understanding how these concepts differ from the typical returns you might see in the stock market. In Part 2, we’ll break down how IRR compares to a standard expected market return and why the timing of cash flows matters.
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