The Difference Between Internal Rate of Return and Return on Investment

by William Pirraglia

    The most common measurement of investment earnings is the Return on Investment. You can quickly see whether your investments have increased or devalued within a measured period of time. The Internal Rate of Return measures the yearly compound rate, or yield, you might enjoy from the amount you invested based on expected cash flows until investment maturity. IRR is more complex than ROI because it measures the timing of cash flows along with the documented increase in an investment's value.

    ROI Simplicity

    The most popular investment measurement, ROI was often the primary traditional measurement used before the dawn of computers for the masses. The mathematical complexity of IRR proved to be too daunting a manual calculation for almost all investors, large and small. ROI uses limited variables and is easily calculated with computer software or a simple pencil and paper. Although a more accurate measurement, calculating IRR is better left to computers.

    Calculation Operations

    Calculating ROI requires only two common operations, division and subtraction. These are math skills familiar to children as young as fifth-graders. Getting an IRR result uses both more complex mathematical formulas and algorithms. While a more accurate method, IRR cam be deemed an "impossible to solve equation" when using manual analytical and mathematical operations. Using only two values, ROI is much easier to calculate.

    ROI Formula

    The ROI formula is simple and straightforward. To calculate ROI all you need is the following calculation: (Return - Investment Amount) divided by the Investment Amount. Calculating IRR is much more challenging. Without spreadsheet software or an online IRR calculator, at a minimum, you'll be challenged to get any meaningful result. You may, however, get a world-class headache.

    IRR Formula

    Simply put the various formulas for estimating IRR equal the rate at which NPV, Net Present Value, is zero. Since there is no one single equation to find IRR, you need a "trial and error" mentality to arrive at a useful result. Try this one. First, list the investment amount and the estimated future periodic cash flows. Then use the projected discount rate to find a "discount factor." If the discount rate is 12 percent, the discount factor equals 1 divided by (1 plus the discount rate)^year of the cash flow. Multiply the discount factor by the projected annual cash flows, one year at a time. This gets the Net Present Value rate. When NPV finally equals zero, you'll have the IRR. Got it? Use computer software to avoid anger and frustration.

    ROI and IRR Software

    There are a variety of online calculators and software available to calculate ROI and IRR. You'll receive different numerical results depending on your goal, ROI or IRR. This variety of results further emphasizes the difference between the two calculations. Since both methods are valuable, the availability of software allows you to use both, unlike many investors during pre-computer days.

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    About the Author

    For 34 years Bill Pirraglia served as a senior executive in the banking industry. Since 2005, he has authored articles, blog entries, tips and advice columns, SEO web copy and two published books. He specializes in personal and business finance topics, along with legal articles for clients large and small.

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