When you’re trying to figure out if an investment is actually worth it, you’ll likely encounter two key terms: Return on Investment (ROI) and Internal Rate of Return (IRR). ROI is a pretty straightforward way to measure how profitable an investment is in the short term. IRR, on the other hand, is a more complex calculation that takes into account the time value of money, and therefore, helps evaluate long-term investments.
The goal here is to break down the differences between ROI versus IRR and help you pick the right tool for the job, depending on the context of your investment. We’ll cover the definitions, calculations, and when it makes sense to use each.
What is Return on Investment (ROI)?
Return on Investment (ROI) is a way to measure how profitable an investment is compared to how much it cost. ROI puts potential profits and losses side by side with investment costs. In a nutshell, it tells you what percentage you stand to gain or lose on an investment.
ROI is a fairly straightforward metric. It gives you a quick picture of how profitable an investment is. But it’s also worth noting that ROI is usually calculated over a specific time period.
How to calculate ROI
Here’s the formula for ROI:
ROI = (Net Profit / Cost of Investment) x 100
For example, if you invested Rs. 50,000 and made a profit of Rs. 20,000, your ROI would be 40%. Or if you invested $10,000 and made a profit of $5,000, your ROI would be 50%.
The ROI can be positive (a gain) or negative (a loss).
What is Internal Rate of Return (IRR)?
Internal Rate of Return (IRR) is a way of figuring out the discount rate that makes the net present value (NPV) of all the cash flows from a given project equal to zero. Basically, it’s the discount rate that makes an investment break even, taking into account the time value of money.
IRR is a metric that estimates the potential profitability of an investment, using a discounted cash flow analysis. This means it factors in the idea that money you have today is worth more than the same amount of money you’ll have in the future.
Unlike ROI, which is a relatively simple calculation, IRR is more complex. It’s usually calculated using financial software or a financial calculator. To calculate IRR, you need to understand discounted cash flow and the time value of money, along with exponential multiplication and simple sum notation.
Key Differences Between ROI and IRR
ROI and IRR both help you analyze the potential profitability of an investment, but they work in different ways.
Simplicity vs. Complexity
ROI is pretty straightforward to calculate and understand, which is why it’s often used to evaluate investment performance. On the other hand, IRR is more complex. ROI is expressed as a simple percentage, while IRR uses a discounted cash flow analysis.
Another difference is that IRR relies on predicted or estimated values, while ROI uses actual returns.
Time Value of Money
IRR accounts for the time value of money, meaning that it recognizes that money received in the future isn’t worth as much as money received today. ROI, however, focuses only on the overall value of the investment.
Discounting future cash flows is an important concept because it takes into account things like inflation and the potential for earning interest or returns on that money if you had it today.
Scope and Application
ROI gives you a quick overview of profitability, while IRR provides a more comprehensive analysis in the form of an annualized rate of return. IRR assesses the rate of change over time, while ROI simply shows the overall growth or decline over a specific period.
Because it’s simple, ROI is often used for short-term investments with straightforward cash flows. IRR is better suited for long-term projects with multiple cash flows over an extended period.
When to Use ROI vs. IRR
Both ROI and IRR can help you assess investment performance, but each is better suited to certain situations.
When to use ROI
- For a quick, simple look at an investment’s profitability.
- For evaluating simple, short-term investments where cash flows are straightforward.
When to use IRR
- For capital budgeting decisions and comparing different projects.
- For analyzing long-term investments that involve multiple cash flows over time.
Why not use both?
For a truly comprehensive investment analysis, you might want to calculate both ROI and IRR. Looking at both metrics can give you a more thorough understanding of an investment’s potential profitability, which can help you make better-informed decisions.
Key Takeaways
ROI is a simple metric for measuring the profitability of a short-term investment. IRR is more complex, but it’s a better choice for long-term investments because it considers the time value of money.
Whether you should use ROI or IRR depends on the investment you’re considering, but running both calculations can help you make a more thorough analysis of an investment’s potential profitability and help you make a well-informed decision.