Return on Investment (ROI) vs Internal Rate of Return (IRR)
This article explains the difference between ROI and IRR by way of example. The example is a $100,000 investment which resulted in $108,000 being received at the completion of the investment.
Money In: $100,000
Money Out: $108,000
Money is either gained or lost in an investment. The money gained or lost is simply the Money Out less the Money In. In this case $108,000 - $100,000, which is $8,000.
The ROI is easily worked out as follows:
Money gained or lost
Money In
$8,000 is the money gained, so we divide that by $100,000, which is 0.08 or 8%.
So, the ROI is 8%.
The ROI remains the same regardless of whether the investment lasted 2 months or 20 years.
Achieving 8% return over 2 months is fantastic because you can now reinvest $108,000 soon after you started. If you repeated that process with the same return in the same timeframe you would have compounded your money to $158,487 in a year. As Einstein was supposed to have said, “Compound interest is the eighth wonder of the world.”
But, if you achieved 8% return over 20 years, you would probably be very disappointed as your money would be worth less than when you started, due to inflation.
So how can you tell whether a ROI is a good one or not?
This is where the IRR comes to your rescue, because IRR includes the investment duration (time).
The calculation for IRR is complex and any internet search on IRR will show highly professional people from big companies trying to explain it without confusing you – most do so unsuccessfully. Thankfully Microsoft Excel makes it easy to work out. I will use the result of the calculations so we can focus on why IRR is so good, rather than spend the time stressing our brains trying to understand the formula.
Let’s use the diagram below to pinpoint four different durations and to understand what this tells us about ROI and IRR.
The only time the ROI and the IRR is the same, is at the one-year mark. If you receive an 8% ROI in one year, the IRR is the same at 8%.
If you receive that 8% ROI in 18 months, the IRR is only 5.2% as it took a year and a half to get your money out.
If you receive that 8% ROI in 4 months, the IRR is 26% because if you repeat the 8% ROI on the returned money throughout a year (that is 3 times), at the end of that year you would have $125,892.
If you receive that 8% ROI in 2 months, the IRR is 58% because if you repeat the 8% ROI on the returned money throughout a year (that is 6 times), at the end of that year you would have $158,487.
The quicker the turnaround per cycle with the same ROI, the more money you receive over the period.
In a nutshell
ROI is good, but IRR is a much more reliable friend to your investing.