Internal rate of return (IRR) and return on investment (ROI) are two separate metrics used for determining wins or losses from investments. Determining which metric is better suited for your specific needs requires understanding the difference between the two as well as what goes into the calculation of each of these metrics.
Return on Investment
Also dubbed rate of return, the return on investment(ROI) metric is perhaps the most commonly used in the business world. The ROI tells you how much a company’s or individual’s investments have increased or decreased during a specified time frame. For instance, if you held shares of a company’s stocks and those shares have gone up 30 percent in value over the last year, 30 percent is your ROI. To calculate ROI, you simply subtract the initial investment from the current one and divide the resulting figure by the initial investment.
Internal Rate of Return
Internal rate of returned (IRR), also sometimes called the annualized percentage yield, tells you the yearly compound rate that a firm or individual stands to gain from its investments. This figure takes into account a number of factors, not just increases in investment value, as the ROI does. These factors might include dividends, timing of payouts and taxes. It’s a complicated calculation to make, but some computer programs, like Excel or Google Docs offer an automatic function that simplified calculating IRR.
The key difference between ROI and IRR is the fact that the latter is much more complicated, but also much more comprehensive, than the first. Thus, when you’re simply trying to gain an overall picture of your investment standings, figuring out ROI is usually enough. However, when you need a more accurate, detailed picture of finances, the IRR is a better option.
While IRR can provide a more accurate picture of your financial standing, finding IRR is also contingent on having many more pieces of data than are needed for determining the ROI. Thus, sometimes it’s simply not possible to calculate IRR, or at least to calculate it accurately, since having some, but not all needed data can result in a skewed picture.