Understanding IRR vs ROI: A Comprehensive Comparison

When analyzing potential investments two of the most common metrics used are Internal Rate of Return (IRR) and Return on Investment (ROI). Though related, these metrics calculate returns differently and serve different purposes. This article will explain IRR and ROI in simple terms when each is more applicable, and the key differences between the two.

What is Return on Investment (ROI)?

Return on Investment or ROI measures the profitability of an investment as a percentage of the initial cost It is calculated by dividing the total return of an investment by its initial cost,

The formula is

ROI (%) = (Gain from Investment - Cost of Investment) / Cost of Investment x 100

For example, if you invested $1000 and earned $150 profit, the ROI would be:

ROI = ($150 - $1000) / $1000 x 100 = -15% 

A higher ROI indicates a more profitable investment. ROI can be used to evaluate single investments or compare multiple potential investments. It provides a simple percentage representing total return.

Some key things to note about ROI:

• ROI measures total return over a set period, regardless of timing
• Easy to calculate as a single percentage
• Does not account for the time value of money

What is Internal Rate of Return (IRR)?

Internal Rate of Return or IRR is the discount rate that makes the net present value (NPV) of a project zero. It represents the annual rate of growth of an investment.

IRR is calculated using a complex formula that iteratively solves for the discount rate that sets NPV equal to zero. Financial calculators or Excel can determine the IRR.

For example, say an investment of $1000 yields the following cash flows:

• Year 1: $200
• Year 2: $500
• Year 3: $700

The IRR would be the discount rate that makes the NPV of these cash flows equal to the initial $1000 investment.

Some key things to note about IRR:

• Specifies an annual rate of return percentage
• Accounts for the time value of money
• More complex to calculate than ROI

When to Use ROI vs IRR

ROI is Better for:

• Comparing total returns of investments
• Simpler investments with a set time period
• Communicating returns to novice investors

IRR is Better for:

• Assessing annual growth rates
• Comparing projects with uneven cash flow timings
• Evaluating complex investments with many cash flows

ROI provides a straightforward percentage representing total profitability over a set investment period. IRR accounts for the time value of money and is better for comparing investments with uneven cash flow timings.

Key Differences Between ROI and IRR

Here are some of the main differences between these two investment return metrics:

• Calculation – ROI has a simple formula while IRR uses a complex NPV calculation.

• Time Value of Money – IRR considers the time value of money by discounting future cash flows. ROI does not account for this.

• Reinvestment Rate – IRR assumes reinvestment of interim cash flows at the IRR rate. ROI does not make this assumption.

• Cash Flow Timing – IRR accounts for the timing of investment cash flows. ROI only looks at total return over the full period.

• Ease of Use – ROI is easier to understand and calculate. IRR is more complex.

• Evaluation Purpose – ROI measures total profitability while IRR focuses on annual return rate.

When Should You Use Each Metric?

Here are some guidelines on when each metric is most applicable:

ROI Tends to Work Better For:

• Comparing returns between simple investments
• Communicating investment performance to new investors
• Evaluating total return over a set time period
• Assessing real estate investments or fixed assets

IRR Tends to Work Better For:

• Choosing between projects with complex or uneven cash flows
• Ranking potential venture capital investments
• Comparing capital budgeting projects with different lifespans
• Incorporating the time value of money

Real World Examples

Let’s look at some examples of how ROI and IRR could be used to evaluate potential investments:

Stock Investment

John invested $10,000 in stock XYZ. After 3 years, he sold the shares for $15,000.

• ROI = ($15,000 – $10,000) / $10,000 = 50%
• IRR is the annual rate that makes NPV = 0. Using a financial calculator, the IRR is 15%

In this case, both metrics tell a similar story. The total ROI over 3 years was 50% and the annual IRR was 15%.

Rental Property Investment

Mary is considering buying a rental property for $200,000. She forecasts it will generate $20,000 in positive cash flow each year for the next 10 years. After that, she can sell it for $300,000.

• ROI = ($20,000 x 10 + $300,000 – $200,000) / $200,000 = 60%
• IRR is 13.5% annually

Here the ROI is higher as it measures the total return. But the IRR shows the annual rate of return is 13.5%, accounting for TVM.

New Equipment Purchase

A company can invest $1 million in new equipment. This is forecast to save $250,000 in operating costs each year for the next 7 years.

• ROI is unclear as there is no revenue gain, only cost savings
• IRR is 16.5%, the rate that makes NPV of cost savings = $1 million initial investment

In this case, IRR is more relevant as there are no direct revenues to determine ROI. IRR helps evaluate the annual return on cost savings.

The Bottom Line