Internal rate of return and return on investment are two common metrics used to show how an investment has performed over time. Although similar, these two metrics describe investment performance in very different terms.
Let's start simple Return on investment is the easier of the two methods. It describes the percentage gain or loss from an investment over any period of time. If you bought an investment for $50 and today it is worth $75, you're return on investment is 50%. That is:
Investors should be careful to understand and incorporate any costs associated with an investment in their calculation. For example, taxes, fees, and carrying costs can all subtract from the value of the investment when sold. In those cases, those expenses must be subtracted from the "current value" in the equation above before completing the math.
Return on investment works for any time period. It is simply a reflection of the change from one point in time to another. That can be problematic when evaluating an investment over a long period of time. For example, a 100% ROI seems strong without knowing that it took 100 years to achieve that return.
Enter internal rate of returnThe internal rate of return solves this problem by calculating the percentage return on an annualized basis regardless of the actual investment period. Hold an investment for one year, three years, or 100 years, it doesn't matter. Internal rate of return will tell you the annualized percentage returns of that investment over any period of time.
For an investment that lasts exactly one year, the internal rate of return is the same as the return on investment. From the example above, our stock must grow 50% per year to grow from $50 to $75 over a one year period. That's pretty simple.
The hard part comes in when calculating the returns on an annualized basis, over multiple years, and still incorporating taxes, fees, dividend payments, and other cash expenses or gains.
The easiest way to do these more challenging calculations is with a spreadsheet. We'll use Excel to demonstrate an example.
The screenshot below shows the cash spent and cash returned for a four year stock investment. In year one, there is the cash outflow to purchase the stock and pay brokerage fees. In years two and three, the company pays a dividend of $5 per year. For simplicity, we'll assume those dividends are not reinvested. Finally, in year four, the stock is sold for $165, and we also subtract taxes and brokerage fees. We also assume that we were able to collect another $5 dividend check in year four, prior to selling.
Below each year, we've added together all the cash outflow and inflow. That step is critical, as those net cash flow figures will determine our internal rate of return.
The next step is to use the =IRR() formula in Excel to calculate our internal rate of return.
That formula returns 16.2%, which is our internal rate of return for this investment. Remember, the IRR is the annualized percentage return. The 16.2% represents the average annual return over the four years of this investment.
The ROI of this investment calculates to 57%, which includes the dividend gains and the costs of brokerage fees and taxes. This ROI represents the simple percentage gain over the entire four year period, not annualized as in the IRR calculation.
Used together, these two metrics tell a robust storyAt the end of the day, each metric is useful in its own way. For monitoring your performance over the long term or against benchmarks like the S&P 500, the internal rate of return is more informative because it describes the performance in consistent, annual terms. However, for determining short term gains or understanding your cash-on-cash returns, the return on investment number gives you everything you need with a much simpler calculation.
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