A simple guide to ROI and IRR Featured
Dont understand ROI AND IRR?
Here is a simple guide to ROI and IRR ↓
🟢 ROI shows the return in DOLLARS
🟢 IRR shows the ROI adjusted for TIME
You need both to understand the return on investment.
Here is an Explanation:
🟢 Lets start with the easier one — ROI.
ROI means Return on Investment.
(↑ btw, this is often called MOIC or Cash-on-Cash)
▪️ If I invest $100 and get back $200 the ROI is 2.0x = ($200 / $100)
▪️ If I invest $100 and get back $300 the ROI is 3.0x = ($300 / $100)
Make sense?
But now lets introduce TIME...
If you make 2.0x in one month, great!
But if you make 2.0x in 100 years... not so great.
So you need a way to measure my ROI over TIME as well.
🟢 Thats where IRR comes in.
IRR means Internal Rate of Return,
and while IRR is often used alongside NPV & DCF analysis,
lets simplify it further...
Lets say IRR means the annualized rate of return for an investment.
In other words, what percent did I make PER YEAR?
10%? 25%?
Lets go back to the examples above...
▪️ 2.0x in one month: 409,500.0% (← ...uh what?)
▪️ 2.0x in 100 years: 0.7% (← makes more sense)
This is where IRR can be misleading and why its common for private equity folks to say you cant spend IRR.
IRR calculates an ANNUALIZED percent return, so big returns in the early days can skew the numbers.
If I crush it in the first month, my IRR formula says, whoa! youre going to keep this up all year — nice!
But in reality, it wont play out that way.
The IRR starts to feel more palatable as time goes by, for example:
▪️ 2.0x after 6 months: 300%
▪️ 2.0x after 1 yr: 100%
(↑ I doubled up in one year, and IRR is an annualized number, so its 100%)
▪️ 2.0x after 2 yrs: 73%
▪️ 2.0x after 3 yrs: 44%
▪️ 2.0x after 4 yrs: 32%
(↑ see how it drops off steeply & then smooths out?)
🟢 And this is why you need BOTH.
Without the other, they can both be misleading.
So you compare them side-by-side:
As of [date] my ROI was [X], and my IRR was [Y].
———
Note this gets trickier once you factor in the timing of cash flows...
If you invest $100, you get $120 back in month 2 and $80 back in month 6,
Ive still made 2.0x, but your IRR will be much higher than 300%.
(↑ a conversation for another time).
Important Links:
Here is a simple guide to ROI and IRR ↓
🟢 ROI shows the return in DOLLARS
🟢 IRR shows the ROI adjusted for TIME
You need both to understand the return on investment.
Here is an Explanation:
🟢 Lets start with the easier one — ROI.
ROI means Return on Investment.
(↑ btw, this is often called MOIC or Cash-on-Cash)
▪️ If I invest $100 and get back $200 the ROI is 2.0x = ($200 / $100)
▪️ If I invest $100 and get back $300 the ROI is 3.0x = ($300 / $100)
Make sense?
But now lets introduce TIME...
If you make 2.0x in one month, great!
But if you make 2.0x in 100 years... not so great.
So you need a way to measure my ROI over TIME as well.
🟢 Thats where IRR comes in.
IRR means Internal Rate of Return,
and while IRR is often used alongside NPV & DCF analysis,
lets simplify it further...
Lets say IRR means the annualized rate of return for an investment.
In other words, what percent did I make PER YEAR?
10%? 25%?
Lets go back to the examples above...
▪️ 2.0x in one month: 409,500.0% (← ...uh what?)
▪️ 2.0x in 100 years: 0.7% (← makes more sense)
This is where IRR can be misleading and why its common for private equity folks to say you cant spend IRR.
IRR calculates an ANNUALIZED percent return, so big returns in the early days can skew the numbers.
If I crush it in the first month, my IRR formula says, whoa! youre going to keep this up all year — nice!
But in reality, it wont play out that way.
The IRR starts to feel more palatable as time goes by, for example:
▪️ 2.0x after 6 months: 300%
▪️ 2.0x after 1 yr: 100%
(↑ I doubled up in one year, and IRR is an annualized number, so its 100%)
▪️ 2.0x after 2 yrs: 73%
▪️ 2.0x after 3 yrs: 44%
▪️ 2.0x after 4 yrs: 32%
(↑ see how it drops off steeply & then smooths out?)
🟢 And this is why you need BOTH.
Without the other, they can both be misleading.
So you compare them side-by-side:
As of [date] my ROI was [X], and my IRR was [Y].
———
Note this gets trickier once you factor in the timing of cash flows...
If you invest $100, you get $120 back in month 2 and $80 back in month 6,
Ive still made 2.0x, but your IRR will be much higher than 300%.
(↑ a conversation for another time).
Important Links:
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