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Return on investment (ROI) and internal rate of return (IRR) are two important metrics used in evaluating investments. However, each metric is calculated differently and tells a different story.
ROI tends to be more common, in part because it is easier to calculate. But IRR is also useful, especially when assessing 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 an investment. It is calculated by taking the change in an investment from start to finish and dividing that amount by the initial investment.
For example, suppose a business invests $10,000 in a new project. After three years, the new undertaking has yielded $5,000 in profit. The ROI on the project after three years would then be $5,000 divided by $10,000, or 50 percent.
ROI can also be negative. Using the same example, suppose the business spends $10,000 and after one year it hasn’t generated any additional profit. As a result, the business spends an additional $5,000 in the first year. In this case, the ROI would be -50 percent.
ROI is often used in the context of stock market investments and is perhaps easier to understand in this context. For example, suppose you buy one share of stock for $100. If after one year its value has increased to $125, your ROI would be 25/100, or 25 percent. If its value dropped to $75, ROI would be -25 percent.
Internal rate of return (IRR): What is it and how is it calculated?
Internal rate of return is a metric that can help evaluate the returns of potential investments. To find IRR, the calculation sets the net present value of the project’s future cash flows equal to zero and then solves for the investment’s IRR. This calculation produces 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 complicated than the ROI calculation. For the same reason, it is mostly used by financial analysts, venture capitalists and businesses rather than individual investors.
While IRR is a more complex calculation, we can understand its usefulness with a simple example. Imagine a big business spends $1 million in an effort to reduce its environmental impact. It expects the project to generate an additional $200,000 in profit per year from environmentally conscious consumers for the next five years and then $100,000 a year for the subsequent five years.
The IRR then shows the rate needed 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 the returns from various projects and decide which is the best among them or which surpasses a given minimum return threshold. The IRR calculation helps “normalize” the cash flows from potential investments and provides a quick way to assess alternatives.
Differences between ROI and IRR
Both ROI and IRR are useful metrics, but there are significant differences between them. For example, chances are high that you have never used IRR when deciding whether to invest in a company or buy an exchange-traded fund (ETF). Indeed, individuals are more likely to use ROI when evaluating investments, while IRR is more often used by financial analysts and businesses.
This is because not only is IRR more complicated to calculate, but also it reveals different things about an investment than ROI. ROI is a simple calculation that shows the amount an investment returns compared to the initial investment amount. IRR, on the other hand, provides an estimated annual rate of return for the investment over time and offers a “hurdle rate” for comparing other investments with varying cash flows.
Generally, IRR calculates the annual return on an investment or project, while ROI is the overall rate of return from beginning to end.
ROI and IRR are two metrics that can help investors and businesses evaluate investments. IRR tends to be useful when budgeting capital for projects, while ROI is useful in determining the overall profitability of an investment expressed as a percentage. Thus, while both ROI and NPV are useful, the right metric to use will depend on the context.