Two important measurements often used in the world of investing are internal rate of return (IRR) and return on investment (ROI). The IRR is used to measure the expected performance of an investment based on estimated future cash flows, while ROI is widely used to measure an investment’s overall profitability. Both are powerful tools that can help investors make important decisions for their business or investment portfolio.
What’s the Difference Between IRR and ROI?
|Internal Rate of Return (IRR)||Return On Investment (ROI)|
|IRR is the discounted rate of all future expected cash flows of an investment or project||ROI is the percentage growth (or loss) of an investment divided by the initial cost of the investment|
|IRR is used to measure the estimated cash flows of investments against a benchmark||ROI is used to analyze the growth and efficiency of an investment|
|Commonly used by financial analysts||Commonly used by everyday investors and financial institutions|
|Calculating IRR requires a complex formula||ROI is quick and easy to calculate|
What They Measure
IRR is a formula used to measure the estimated return of an investment or project. To measure the IRR, a business would discount its expected future cash flows at a rate that makes the net present value of all the cash flows equal to zero. The rate required to discount these cash flows to zero is the internal rate of return of that investment, expressed as a percentage.
To determine whether an investment is worthwhile, a business would compare the IRR to its hurdle rate, or minimum acceptable rate of return.
ROI, on the other hand, involves a simple calculation to measure the profitability of an investment. It is the growth of the investment divided by the initial cost expressed as a percentage of growth or loss.
When To Use IRR vs. ROI
IRR is used to determine whether a project or investment is worth pursuing based on its expected future cash flows. Here’s an example.
Say a commercial landscaping business is expanding its operations and wants to purchase a new commercial-sized lawnmower. The lawnmower costs $5,000 and is expected to produce an additional $2,500 per year in revenue for the next five years. The owner can use the IRR to determine whether the investment is worth the cost.
In the table below, the “Expected Cash Flow” column shows the annual revenue expected from the purchase of a new lawnmower. However, we need to take into account the fact that $2,500 will be worth less in one year, two years, and five years than it is today. In other words, $2,500 will have less purchasing power in the future. This is due to inflation, or, the continual rising costs of goods and services as time goes on.
The column labeled “Net Present Value of Cash Flows'' tells us the discounted dollar amount of $2,500 of revenue expected to be received in the future, valued in today's dollars. This means that $2,500 from today will only have $1,772 in purchasing power after one year. To get this number, we can use a financial calculator or the PV formula in Microsoft Excel or Google Sheets.
|Year||Cost||Expected Cash Flow||Net Present Value of Cash Flows|
To calculate the IRR, the landscaping company would want to determine the discount rate required to make the net present value of $2,500 for each of the five years equal to zero. They could use an online IRR calculator or use the IRR formula in Microsoft Excel or Google Sheets. In this case, the IRR is 41.041% per year.
ROI is a much simpler formula used to calculate the profitability of an investment. Say an individual with an investment portfolio of 25 stocks wants to calculate the overall growth of his portfolio over the course of a year. He invested a total of $10,000 in January, and his portfolio is worth $11,000 on December 31.
To calculate the ROI, he would take the total growth of $1,000 and divide it by the initial investment of $10,000. In this case, his ROI would be 10%.
Who Uses IRR vs. ROI
Due to its complexity and unique use cases, IRR is more likely to be used by institutional investors, company analysts, portfolio managers, venture capitalists, and business owners. Individual investors can also use IRR to estimate the future cash flows of a stock, for example, to estimate its growth and expected return.
ROI is used by investors of all experience levels and positions, including finance executives at major companies, portfolio managers, and average investors saving for retirement.
The Bottom Line
Both IRR and ROI are measurements used by investors to determine the suitability of a particular investment. ROI tells investors the total growth or loss of their investments in a given timeframe, whereas IRR tells investors the annual expected return of an investment or project. It is the rate that makes the net present value of a project’s expected future cash flows equal to zero.
ROI measures the overall profitability or loss of an investment expressed as a percentage. It is the total growth of a portfolio divided by the initial investment. Whether you use IRR or ROI will depend on your overall investment or business objective.