The Difference Between Internal Rate of Return and Return on Investment

You don't need an MBA to understand what makes for a successful investment: ending up with more money than you started with. The extra money is your "return," and there are all sorts of ways to measure return. Two of the most common and most popular metrics are return on investment, which is a fairly simple concept, and internal rate of return, which is more complicated.

Return on investment, or ROI, simply expresses the return as a percentage of the initial investment. For example, say you invest $1,000 in a short-term investment that pays you back $200 after the first year, $250 after the second, $300 after the third year and $400 at the end of the fourth and final year. You invested $1,000 and got back $1,150. Your return is $150, so your return on investment is $150/$1,000, or 15 percent – easy as pie.

The problem with return on investment is that it ignores the "time value of money" – a phrase reflecting the fact that a dollar in your wallet today will have a different value than a dollar in your wallet a year from now, and both will have a different value from $1 five years from now. A $1,000 investment that earns $150 in four years has a 15 percent ROI, but so does one that earns $150 in five years, or 10 years, or 25 years. However, earning $150 within four years is much preferable to getting it over 25 years.

For one thing, inflation will chew up the value of that $150 much more over 25 years than over four. For another, the faster you get your mitts on that $150, the faster you can reinvest it and earn more money.

You put money into an investment, and it starts to earn a return. Over the life of the investment, you'll get back more money than you put in, unless you picked a lousy investment. Obviously, your money has grown, and the ROI tells you your total growth start-to-finish. But most investors find it more useful to know the annual rate at which their money grows.

That's where internal rate of return, or IRR, comes in. IRR is the annual return that makes the initial investment "turn into" future cash flows. In the previous example – a $1,000 initial investment with projected annual cash flows of $200, $250, $300 and $400 – the internal rate of return is about 5.211 percent. When the investment increases by 5.211 percent a year, it generates enough money to provide the four cash flows, and at the end of the four-year investment, all the money has been paid out.

Buckle your seat belt and follow the math to see how it works:

• Year 1: You invest $1,000. Your investment earns a 5.211 percent return in the first year, taking the balance to $1,052.11. You take a payment of $200, dropping the investment to $852.11.
  
• Year 2: Investment gains 5.211 percent to $896.50, then pays $250, for a new total of $646.50.
• Year 3: Investment gains 5.211 percent to $680.19, pays $300, drops to $380.19.
  
• Year 4: Gains to $400, pays $400. Done!

Since it doesn't account for the time value of money, return on investment works best when comparing investments over equal time spans. A 15 percent ROI on a four-year investment beats a 10 percent ROI over four years, for example. Internal rate of return, on the other hand, accounts for the time value of money. It considers not only the amount of your return but also the timing — when you receive it – so you can use it to compare investments with different time spans.

The ROI formula is simple: Divide your return by your upfront investment and call it a day. The IRR formula is way more complicated. Financial calculators and spreadsheet programs have built-in IRR functions that do the work for you. Let them.

For the investment in the example, the formula is $1000 = [$200/(1+IRR)] + [$250/(1+IRR)^2] + [$300/(1+IRR)^3] + [$400/(1+IRR)^4].

Solving for IRR is trial and error; you have to keep plugging numbers in for IRR until you get the right one. Honestly, use a calculator or spreadsheet.