Return on Investment (ROI) Vs. Internal Rate of Return (IRR): How They Differ

Return on Investment (ROI) and Internal Rate of Return (IRR) are two important metrics used in investment evaluation. However, each metric is calculated differently and tells a different story.

Return on investment is more common, in part because it is easier to calculate. But IRR is also useful, especially when evaluating potential new investments. Here’s how the two metrics differ.

Return on Investment (ROI): What is it and how is it calculated?

Return on investment is a simple calculation that shows the total percentage increase or decrease of the investment. It is calculated by taking the change in investment from start to finish and dividing that amount by the original investment.

For example, suppose a business invests $10,000 in a new project. After three years, the new venture has brought in $5,000 in profit. The project’s return on investment after three years will be $5,000 divided by $10,000, or 50 percent.

ROI can also be negative. Using the same example, suppose a business spends $10,000 and after one year has generated no additional profit. As a result, the business spends an additional $5,000 in the first year. In this case, the ROI will be -50 percent.

ROI is often used in the context of stock market investing and is perhaps easier to understand in that context. For example, suppose you buy one share for $100. If after one year its value increases to $125, your ROI will be 25/100, or 25 percent. If its value drops to $75, the ROI will be -25 percent.

Internal Rate of Return (IRR): What is it and how is it calculated?

The internal rate of return is a metric that can help assess the return on potential investments. To find the IRR, the calculation sets the net present value of the project’s future cash flows equal to zero and then decides on the investment’s IRR. This calculation gives a single annual rate of return for an investment.

Due to the complexity of determining the IRR of a project or investment, it uses a formula that is more complex than calculating ROI. For the same reason, it is mostly used by financial analysts, venture capitalists and firms, rather than individual investors.

While IRR is a more complex calculation, we can understand its usefulness with a simple example. Imagine that a large business spends $1 million in an effort to reduce its environmental impact. The project is expected to generate an additional $200,000 in profit per year from environmental awareness for the next five years, and then $100,000 per year for the next five years.

The IRR then shows the rate required for the cash flows to equal $1 million, the initial investment. In this example, the IRR is 9.82 percent.

IRR is useful because it can help managers and analysts compare returns from different projects and decide which is the best among them or which exceeds a given minimum return threshold. The IRR calculation helps to “normalize” the cash flows of potential investments and provides a quick way to evaluate alternatives.

Differences between ROI and IRR

Both ROI and IRR are useful metrics, but there are significant differences between them. For example, there’s a good chance you’ve never used IRR when deciding whether to invest in a company or buy an exchange-traded fund (ETF). In reality, people are more likely to use ROI when evaluating investments, while IRR is more commonly used by financial analysts and businesses.

This is because not only is IRR more complicated to calculate, but it also reveals different things about the investment than ROI. Return on investment is a simple calculation that shows the amount an investment returns compared to the original amount of investment. IRR, on the other hand, provides an estimated annual rate of return for the investment over time and offers a “bar” against which to compare other investments with different cash flows.

Typically, IRR calculates the annual return on an investment or project, while ROI is the total rate of return from start to finish.

Bottom row

ROI and IRR are two metrics that can help investors and businesses evaluate investments. IRR is usually useful in capital budgeting for projects, while ROI is useful in determining the overall profitability of an investment expressed as a percentage. Thus, while ROI and NPV are useful, the correct metric to use will depend on the context.

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