It’s essential to understand your potential returns when evaluating different investment options to meet your financial goals. For example, how much can you expect to earn in a year if you invest $10,000 today?
There are different methods by which investors can calculate their investment’s actual and potential returns. The internal rate of return (IRR) and return on investment (ROI) are two commonly used methods.
When evaluating the performance of an investment, it is important to consider both the target and actual IRR. What does this mean, for instance, exactly if you say a particular investment earns 12.5% IRR? And what does that mean by saying that over 5 years you have earned a 25% ROI?
This article compares IRR vs ROI and breaks down the concepts that can be confusing. We’ll also explain how to interpret IRR vs. ROI when doing your own personal due diligence on potential investments.
What is Return On Investment (ROI)?
Return on investment, or “ROI,” is a popular metric in stock portfolios that refers to the percentage increase or decrease in a cash investment over time. In simple terms, ROI is a method of measuring the gain or loss produced by an investment in comparison to the number initially invested. Essentially, it establishes the rate of return on investment for a specific opportunity.
The return on investment is relatively easy to calculate. Subtract the original cash investment from the current invested capital. This provides you with the raw dollar value increase or decreases over the course of the investment. Second, divide this number by the initial cash investment.
Return On Investment (ROI) Formula
ROI can be calculated for any type of activity when there is an investment and a measurable outcome from the investment. However, ROI can be more accurate over a shorter time period. If ROI must be calculated for several years, it is difficult to accurately predict a future outcome that is so far away.
ROI is much easier to calculate and, as a result, is frequently used before IRR. However, technological advancements have enabled IRR calculations to be performed using the software. As a result, IRR is now frequently used.
Example of the ROI Formula Calculation
An investor purchases a property X, which is valued at $5,000,000. Two years later, the investor sells the property for $10,000,000.
We use the investment gain formula in this case.
ROI = (10,000,000 – 5,000,000) / (5,000,000) = 1 or 100%
What is Internal Rate of Return (IRR)?
Internal rate of return (IRR) is more difficult to calculate than the return on investment (ROI). The internal rate of return formula, on the other hand, has the advantage of taking into account the timeframe over which investments are made.
This can make it easier to compare asset portfolios and and choose the one with the highest potential for growth. IRR is typically expressed as an annualized rate of return—the average percentage by which any outstanding principal grows during each year that your investment matures.
In other words, the IRR represents the annualized percentage rate earned on each dollar invested for each period of investment (i.e., any money that is “outstanding” or not repaid continues to earn the IRR at an annual rate, whereas any repaid principal no longer earns interest).
Internal Rate of Return (IRR) Formula
To calculate IRR, first set the Net Present Value of future cash flow to be equal 0 and then solve for the discount rate (r). The discount rate is the expected return on any alternative projects. If you want to compare similar investments, use the one with the higher IRR and similar parameters.
What is NPV?
The value of the net cash flow after discounting is known as the net present value. To calculate NPV, you must first know the cash inflow and cash outflow of the project or company over a given time period, such as five years. Once you’ve determined the net cash flow, you’ll need to calculate the discount factor of present value. As an example, take 10%. This factor is sometimes used in combination with the cost of capital.
Positive NPV occurs when the rate of return is low or there is a large amount of positive net cash flow. In order to calculate IIR, we use a low rate of return to find the rate that could result in a positive NPV.
Zero NPV is exactly come up from the using IRR in discounting. Once you find the IRR, you test if the NPV for the project you are assessing got zero value or not.
Well, basically the negative NPV result from using a large amount of rate of return or discount factor. We find the rate that could make the negative NPV so that we could get the rate that makes zero NPV.
Example of Internal Rate of Return (IRR)
The IRR is presented as a percentage. In this instance, the found IRR is 10%. Assuming that the business is less than 10%, this would represent a good investment. If the ending NPV does not equal zero, the percentage must be adjusted accordingly until that goal is reached. The rate on return, after properly calculated, can be compared to other investments to determine what is ultimately worth the money.
As mentioned in the example below, finding the exact rate that balances to 0 can take a bit of trial and error, and programs such as Microsoft Excel are commonly used to make this task easier.