There are a lot of different ways to measure investment performance, though few metrics are more popular and meaningful than return on investment (ROI) and internal rate of return (IRR). Across all kinds of investments, ROI is more common than IRR, largely because IRR is more confusing and difficult to calculate.
Firms use both metrics when budgeting for capital, and the decision about whether to undertake a new project often comes down to the projected ROI or IRR. Modern computers make calculating IRR much easier, so deciding which metric to use boils down to which additional costs need to be taken into consideration.
There's another important difference between IRR and ROI. ROI tells an investor about the total growth, start to finish, of the investment. IRR tells the investor what the annual growth rate is. The two numbers should normally be the same over the course of one year (with some exceptions), but they won't be the same for longer periods of time.
Return on Investment: The Simple Yardstick
Return on investment – sometimes called the rate of return (ROR) – is the percentage increase or decrease of an investment over a set period of time. It is calculated by taking the difference between current (or expected) value and original value, divided by original value and multiplied by 100.
For example, suppose an investment was initially made at $200 and is now worth $300. The equation for this ROI would be (300 - 200) / 200) x 100, or 50%. This calculation works for any time period, but there's a risk in evaluating long-term investment returns with ROI – an ROI of 80% sounds great for a five-year investment but not so great for a 35-year investment.
While ROI figures can be calculated for nearly any activity into which an investment has been made and an outcome can be measured, the outcome of a ROI calculation will vary depending on which figures are included as earnings and costs. The longer an investment horizon, the more challenging it may be to accurately project or determine earnings and costs and other factors such as the rate of inflation or the tax rate.
It can also be difficult to make accurate estimates when measuring the monetary value of the results and costs for project-based programs or processes (for example, calculating the ROI for a Human Resources department within an organization) or other activities which may be difficult to quantify in the near-term and especially so in the long-term as the activity or program evolves and factors change. Because of these challenges, ROI may be less meaningful for long-term investments.
Internal Rate of Return: Trial and Error
Before the age of computers, very few people took the time to calculate IRR. There isn't really a set equation for IRR; it's more of a concept than a true formula. The ultimate goal of IRR is to identify the rate of discount, which makes the present value of the sum of annual nominal cash inflows equal to the initial net cash outlay for the investment.
Before figuring out IRR, you need to understand the concepts of discount rate and net present value (NPV). To figure out these terms, consider the following problem: A man offers you $10,000, but you have to wait one year to receive it. How much money would you optimally pay, today, to receive that $10,000 in a year?
In other words, you're looking for the present equivalent (the NPV) of a guaranteed $10,000 in one year. You can accomplish this by estimating a reverse interest rate (discount rate) that works like a backward time value of money calculation. For example, if you use a 10% discount rate, $10,000 in one year would be worth $9,090.90 today (10,000 / 1.1).
Back to the IRR: The IRR equals the discount rate that makes the NPV of future cash flows equal to zero. It tells you what the annualized rate of return will be for a given investment – no matter how far into the future – and a given expected future cash flow.
For example, suppose you need $100,000 to invest in a project, and you estimate that the project will generate $35,000 in cash flows each year for three years. The IRR is the rate at which those future cash flows can be discounted to equal $100,000.
IRR assumes that dividends and cash flows are reinvested at the discount rate, which is not always the case. If the reinvestment isn't as robust, IRR will make a project look more attractive than it actually is. That is why it can be argued that there may be an advantage in using the modified internal rate of return (MIRR) instead.