Return on Investment (ROI) and Internal Rate of Return (IRR) are two popular metrics to measure the performance of an investment. Although the internal rate of return is more complex to find, the calculation has become easier with the help of various software. Usually, organizations deploy both the methods for capital budgeting and find out the expected return on a new venture. However, IRR and ROI give us a different perspective of investment and one can’t use them interchangeably. Thus, understanding the difference between ROI vs IRR is very important to identify the situation in which to use them correctly.
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Return on Investment (ROI)
Simply saying, ROI is the increase or decrease in an investment made over a set period. The calculation is simple and requires you to calculate the difference between current and expected value. For instance, if an investment of $200 has become $300, then the return on investment is
($300-$200)x100/$200 = 50%
ROI is flexible, meaning we can calculate the ROI on anything if the investment is involved. It is a key performance indicator of a portfolio or any other investment by the company. Calculating ROI becomes handy for the managers when making decisions such as buying new machinery, hiring new employees, starting a new process, or adding a new department and so on.
Further, companies also calculate ROI of various activities such as marketing campaigns running in the organization, new PR policy and so on. Companies do this to estimate the cost involve in these campaigns and to determine if these are beneficial to the company or not.
However, the accuracy of calculating ROI depends on what is taken as cost and return. Further, it sometimes gets difficult to assess the cost and value of the project. In such cases, ROI might not give an accurate answer.
Internal Rate of Return (IRR)
Companies use this metric for capital budgeting estimates and to assess the profitability of potential investments. Also, the firms calculate the IRR when undertaking expansion plans or setting the budget. The mechanism helps companies to decide the project in which the investment should be made.
Simply put, IRR is the discount rate that makes the net present value of all the cash flows from a specific project as zero. The formula for calculating ROI
IRR = R1 + (NPV1 x (R2 – R1))/(NPV1-NPV2)
R1, R2 = discount rates
NPV1 = higher net present value
NPV2 = lower net present value
IRR is useful in the projects where metrics such as mortgage analysis, private equity investments, and expected return on the stocks are involved. It is a go-to metric when a company is evaluating two projects, and wants to know which of the two is better.
The cost of capital is not taken into consideration while calculating the IRR. Also, the IRR calculation assumes that all the cash flows that a business earns during the life of the project is re-invested at the same rate as IRR.
ROI vs IRR – Difference
|Internal Rate of Return (IRR)||Return on Investment (ROI)|
|The metric is useful for calculating the expected rate of return on investment for the long-term.||ROI is useful to find out the performance of an investment made for short-term. ROI and IRR will be same if investment lasts for exactly one year.|
|Managers take into account the time value of money while calculating the IRR. Therefore, it is useful for calculating the annual growth rate.||This method is useful to calculate and define the growth rate from beginning to end of the investment period.|
|The discount rate in the IRR makes the difference between current investment and the future NPV zero.||Return on Investment, on the other hand, is [(Expected value – Original value)/ Original Value] x 100|
|The formula takes into consideration several factors, and therefore, gets a bit difficult to calculate.||Since ROI does not take future value of money into the account, the calculation becomes relatively easy.|
ROI vs IRR – Similarities
- Both represent the average annual return of investment.
- One can use them as a backward-looking evaluation of a completed investment or a forward-looking estimate of performance.
- Both the metrics are expressed in terms of percentage allowing quick evaluation and comparison.
Both ROI vs IRR have their own strengths and weaknesses. ROI is simple to calculate and easy to understand but does not take into account the time value of money. IRR, on the other hand, considers the time value of the money but is comparatively complex to calculate and understand.
So, it is better, if a company or investor or analyst uses both the metrics to get valuable insight into an investment’s past or potential performance going ahead. For instance, one can use IRR for evaluating the performance over the long-term or against benchmarks, such as the S&P 500. However, for evaluating short-term gains or for the cash-on-cash returns, one can go for the ROI.1,2