Investment is primarily about earning returns. And there are many ways to measure the performance of your investment. In this article we will be looking at three commonly used metrics – Return on Investment (ROI), Internal Rate of Return (IRR) and Net Present Value (NPV). We will also compare ROI vs IRR vs NPV and see the similarities and differences between them.
Let’s begin by understanding each of them separately:
Return on Investment (ROI)
ROI is probably one of the most commonly used measures of investment. When you invest, some of the few questions that you seek an answer for are:
- Do the expected returns justify the risk or costs associated with investment?
- Is the investment profitable?
- How much money will I make from my investment?
ROI is a ratio/percentage that measures the percentage of return relative to the investment cost. ROI is determined by dividing the investment return by the investment cost. Let’s look at an example
John invests in 100,000 for 5 years and incurs additional costs of 25,000. At the end of five years, he receives a credit of 150,000 in his account. In this case, the Return on Investment (ROI) is calculated as follows:
Total costs = 100,000 + 25,000 = 125,000
Total gains = 150,000
ROI = ((Gains – Investment Costs) / Investment Costs) x 100
= ((150,000 – 125,000) / 125,000 )x 100
= (25,000 / 125,000 ) X100
Remember, this is a simplified calculation to explain ROI. Before calculating this ratio, it is important to consider all costs and gains relevant to the investment alone. Given ROI is measured in percentage terms, it can be used to compare with other investments to select best options.
ROI is simple to calculate but has limitations. For instance, it does not measure the return over a period of time. For example, let’s consider John had two investments; ‘Investment A’ that earned him 20% and ‘Investment B’ that earned him 30%. It would appear that Investment B was a better performing investment. However, once you realize that Investment A generated the return over a 2-year period and Investment B generated the return over 5 years it easy to see that Investment A was a better investment than Investment B.
Net Present Value (NPV)
Net Present Value is usually a tool used for capital budgeting to determine the profitability of a project. It compares the present value of cash outflows with the present value of cash flows. A positive NPV indicates the project will be value adding and a negative NPV indicates a net loss.
To calculate NPV you need to know the total investment cost (C0), the total cash inflows during the project (Ct), a discount rate (r)(this is usually the cost of capital) and the duration of the project (t) .
The formula is as follows:
Let’s look at an example to understand this:
Let’s consider another scenario. John is planning to make an investment that will cost him $10,000. John expects to make a return of $3,000 each year for the next 5 years. He determines the appropriate discount rate is 10%. By applying the above formula to this example the NPV will be $1,247.60 indicating that this will be a profitable investment for John.
Even though NPV is a useful tool to evaluate an investment decision, it requires lot of assumptions and estimates leading to potential errors or misleading analysis. It is difficult to estimate the costs and returns with 100% certainty. NPV can be used in combination with other metrics to determine an investment decision.
Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) is the percentage rate of return calculated for each period invested. It is essentially discount that makes the NPV equal to zero. IRR relies on the same formula as the NPV but instead of calculating the NPV it solves for the discount rate to arrive at 0 NPV value.
IRR is a very useful tool to help make an investment decision. If an IRR is greater than the cost capital than it is a profitable investment. If the IRR is lower than the cost of capital than it will be a loss-making investment. It is also used to easily compare different alternatives. Comparing two investment options, the higher IRR will be more attractive.
Let’s think about this through an example. Suppose John has parked his savings in fixed deposit term providing him a return of 4%. He has another investment option providing him an IRR of 9%, John can determine that the investment will provide better returns for him. Obviously, he will have to determine whether the 9% return justifies given the risk of the investment compared to the fixed deposit.
Like other metrics, IRR is not free of issues. It is difficult to evaluate options of different length only using IRR. It is recommended to use it in combination with other metrics such as NPV.
When you are investing, it is important to understand different ways in which you can assess the profitability of your investment. These metrics can help you analyze the past performance of an investment and compare different options. Obviously, these return metrics should always be compared against the risk associated with the investments to determine whether the returns justify the risks.