Both the Internal Rate of Return (IRR) and Return on Investment (ROI) are ways to measure how well an investment is doing, but they answer different questions. In general, the higher IRR is better, but that doesn’t mean more dollars in your pocket.
ROI vs. IRR: Which Should I Use?
ROI is a straightforward metric for gauging an investment’s profitability by comparing net profit to initial investment. IRR goes deeper by considering the time value of money, calculating the discount rate at which the net present value of future cash flows equals zero.
If you want a quick, straightforward assessment, especially for simpler investments, ROI is your go-to. For investments with varied cash flows over extended periods, like a rental property with changing income, IRR provides a more comprehensive insight.
Neither metric should be used in isolation. Pairing ROI and IRR, along with NPV, gives you a holistic view of an investment’s real performance rather than a single number that can be misread.
Is a Higher IRR Better?
Yes, for the most part. A higher IRR usually means a higher annualized rate of return, but it assumes reinvestment at that rate and does not consider the deal’s total dollar size. A short term deal can have a very high IRR but make a lot less total profit than a longer deal with a lower IRR.
IRR is also unreliable for projects with non-conventional cash flows (cash flows that go from negative to positive and back again), because these can produce multiple valid IRRs. That’s why IRR is best played in conjunction with ROI and Net Present Value (NPV), not in isolation.
A flip with 30% IRR over four months sounds better on paper than a rental with 12% IRR over five years, but the rental could put more total cash in your hands. The IRR tells you how fast it grows, it doesn’t tell you how big the prize is.
What is IRR
The Internal Rate of Return (IRR) represents the annualized rate that equalizes the present value of projected cash flows with the initial investment amount. In simple terms, the IRR is like the interest rate you’d earn on an investment. Imagine if you put money into a bank account, and the bank tells you the interest rate they’ll pay you; that’s somewhat like the IRR for an investment.
IRR considers the time value of money, allowing investors to identify the potential profitability of an investment and compare it against other opportunities or a predetermined rate of return. It’s often used alongside other financial metrics like Net Present Value (NPV), Payback Period, and ROI to provide a comprehensive view of an investment’s potential return and feasibility.
How to Calculate IRR: Practical Example
Imagine you’re considering an investment in a new business venture. You’ll invest $10,000 today and expect to receive returns over the next three years as follows:
Year 1: $4,000
Year 2: $4,500
Year 3: $5,000
To find the IRR, you’d set the net present value (NPV) of these cash flows to zero and solve for the discount rate (which is the IRR in this case).
$0 = -$10,000 + ($4,000 / (1+IRR)) + ($4,500 / (1+IRR)^2) + ($5,000 / (1+IRR)^3)
Solving for IRR algebraically is not straightforward due to its iterative nature. Most people use financial calculators, spreadsheet software like Excel (using the IRR function), or specialized financial software to find the IRR.
Plugging these values into Excel’s IRR function, you’d find an IRR of approximately 23.44%. This means the investment is expected to yield an annualized return of 23.44% over the three-year period.
Advantages of IRR
Time Value of Money: By factoring in when cash flows are received, IRR provides a more comprehensive view of an investment’s potential return over time.
Comparability: IRR allows investors to compare the potential profitability of different investments on a level playing field, even with different sizes, durations, or cash flow patterns.
Project Evaluation: IRR is particularly useful for evaluating long-term projects. If a project’s IRR exceeds a company’s required rate of return, it’s typically considered viable.
Neutral to Size: IRR remains consistent whether you’re analyzing a small project or a massive one.
Informs Capital Budgeting: IRR is a cornerstone of capital budgeting, helping investors determine which projects are likely to yield the best returns.
Break-even Point Insight: IRR effectively represents the break-even rate of return, the interest rate at which an investment breaks even in terms of net present value.
Limitations of IRR
Multiple IRRs: Projects with cash flows that change direction more than once can produce multiple IRRs, creating ambiguity in decision-making.
Assumption of Reinvestment Rate: IRR assumes future cash flows are reinvested at the IRR itself, which may not be realistic and can overstate the project’s true profitability.
Comparing Projects of Different Lifespans: A shorter project with a higher IRR isn’t necessarily more profitable in absolute terms than a longer project with a slightly lower IRR. In these cases, Modified Internal Rate of Return (MIRR) or NPV gives a clearer picture.
What is ROI?
The Return on Investment (ROI) is a metric that calculates the ratio of the net profit from the investment to the initial amount invested. ROI provides a straightforward percentage that indicates how much return the investment has generated relative to its cost.
How to Calculate ROI: Practical Example
Imagine you decide to invest in a rental property. You purchase the property for $200,000. After owning it for a year, you’ve earned $24,000 in rental income and have incurred expenses of $4,000.
- Determine your net profit:
Net Profit = Rental Income – Expenses – Original Investment
Net Profit = $24,000 – $4,000 – $200,000 = -$180,000 - Apply the ROI formula:
ROI = (Net Profit / Initial Investment Amount) x 100%
ROI = (-$180,000 / $200,000) x 100% = -90%
In this case, the ROI is -90%, indicating a loss during the first year. This is expected for a buy-and-hold purchase, since it counts the full property price as a cost in year one; investors typically track ROI over multiple years or measure it against appreciation and equity gained, not just year-one cash flow.
Advantages of ROI
Simplicity: ROI offers a straightforward calculation that’s easy to understand, providing a direct percentage result.
Versatility: ROI can be applied across stocks, real estate, marketing campaigns, and business projects, enabling comparison across diverse opportunities.
Decision-Making: By quickly assessing profitability relative to cost, investors can make informed choices about where to allocate funds.
Performance Tracking: Regularly calculating ROI helps investors monitor and adjust their portfolios based on actual returns.
Benchmarking: ROI helps compare an investment’s performance against market standards or competing investments.
Limitations of ROI
Time Period Ambiguity: ROI doesn’t inherently account for the time period over which the return is achieved.
Ignores Time Value of Money: Unlike IRR, ROI doesn’t factor in when cash flows arrive, treating future returns the same as immediate ones.
Over-simplicity: A single percentage figure can overlook cash flow patterns, risk factors, or future benefits.
Inconsistent Inputs: What counts as “return” and “cost” can vary, leading to misleading comparisons if not standardized.
Reinvestment Assumption: ROI doesn’t specify the rate at which returns are reinvested, which matters when comparing investments.
Doesn’t Reflect Intangible Benefits: ROI may not capture intangible value like brand recognition or long-term strategic alignment.
IRR vs. Interest Rate: What’s the Difference?
These two get mixed up constantly, but they’re not the same thing. An interest rate is a fixed, contractual cost, the rate a lender charges you to borrow money, or the rate a bank pays you on a deposit. It’s set in advance and doesn’t change based on how your investment performs.
IRR is a calculated output, not a contractual input. It reflects the annualized return of an entire investment, factoring in every cash flow in and out over the life of the deal, including the interest rate you’re paying on financing, plus rental income, appreciation, and expenses. In other words, your mortgage rate is one ingredient that feeds into your IRR, not a substitute for it.
This is also where discount rate and required rate of return fit in. The discount rate is the rate you use to bring future cash flows back to today’s dollars when calculating NPV, and it’s often set equal to your required rate of return, the minimum return you need to make a deal worthwhile. If a project’s IRR is higher than your required rate of return, the investment clears your bar. If it’s lower, the numbers say to pass, even if the deal feels good on paper.
Using IRR and ROI on a Property Investment Loan
The metric you use can differ depending on how the deal is funded. Because a DSCR Loan is underwritten based on the income generated by the property and not your personal income, investors looking at deals financed this way will often look at both IRR (annualized growth rate) and ROI (simple cash on cash) side by side.
And since financing costs have a direct impact on both numbers, you might want to take a look at what DSCR Loans Rates are before you run your projections.
