Both the CEO and the CFO of a large company told me that ROI and IRR are the same thing. They’re not. Interestingly, both executives’ annual bonus was determined by how their ROI compared with other companies in the industry.
I worked for a big company that required a 16% after-tax IRR on new investments. As it happened, the company’s ROI was typically in the 16% range. The Director of Financial Planning told the operating teams that achieving a 16% IRR automatically resulted in a 16% ROI… But he was wrong. It was just a coincidence.
Another company required an 18% pre-tax IRR on new investments, and for several years reported an ROI of about 18%. That was also a coincidence.
ROI and IRR are very different calculations, and are used for very different purposes.
Return on Investment (ROI)
ROI is a measure of how effectively a company is utilizing its capital investment. It measures the company’s profit during a fixed period of time, usually one year, divided by its average assets.
Pretax Profit Before Interest / Average Total Assets, excluding Capitalized Interest (-) Average Non- Interest Bearing Liabilities
Taxes and interest are excluded from the calculation in order to compare the performance of different companies more effectively. A company with a low tax rate, or a highly leveraged company will have very different result from those of a company that has higher taxes or operates with low debt levels, so this calculation removes those variables. Other calculations, such as Return on Equity (ROE) evaluate performance on a more comprehensive basis.
Non-interest bearing liabilities include items like accounts payable and accrued liabilities, which are effectively free financing, so the corresponding assets aren’t really considered to be an investment.
How Useful is ROI?
ROI is a widely used calculation, but we must remember that it measures only one year’s performance, so it can swing widely from year to year if earnings are volatile. This may not be a bad thing in cyclical businesses, in which all companies experience the same environment.
In my opinion, ROI is most useful in established companies that are not growing or contracting at a rapid rate. The book value of a young company or a growing company’s assets is likely to be relatively high, as they invest in future earnings, and haven’t charged off extensive depreciation and amortization.
Conversely, there is an old joke that the best way to increase your ROI is to go out of business, because your investment is declining as you sell off assets, while you still report income from the sale of those assets.
There are plenty of slightly different calculations such as Return on Net Assets (RONA), Return on Capital (ROC) and Return on Invested Capital (ROIC) that can be argued to be more representative of a particular company’s performance, but they all have the same basic objective.
Internal Rate of Return (IRR)
IRR calculates the compound rate of interest earned over the life of a specific investment, using not only the dollar amounts, but also the timing of cash expenditures and cash receipts. Because it uses the concept of the “time value of money,” IRR is used to compare investment opportunities that have very different cash flows.
IRR is based on the concept of Net Present Value (NPV). NPV says that one dollar today is worth exactly one dollar. A promise to receive one dollar a year from now, however, is worth less than a dollar, because you’ve missed the opportunity to earn income on that dollar for a year. If you could earn 10% (the Discount Rate) on your investment, next year’s dollar would be worth only 90.9 cents today ($1.00 divided by 110%). On the bright side, a future expense is also worth less today.
IRR is the Discount Rate at which the NPV of a series of cash flows is zero. That is, the interest rate earned over the life of an investment after the initial investment has been repaid.
Typically, interest and taxes are also excluded from the IRR calculation for comparison purposes, but of course, you will want to see the net leveraged IRR too.
How Useful is IRR?
If you have $1 million cash to invest, should you invest in the project that requires the entire investment up front, then pays nothing for 3 years, when it returns $1.5 million? Or should you go for the one that requires a $500,000 investment in each of the first two years, and then pays $350,000 a year for the next 5 years? There are obviously a lot of other factors to consider, but IRR will tell you which one pays a higher return.
Similarities Between ROI and IRR
None… ROI and IRR are entirely different calculations.
Does your CFO explain and discuss financial metrics with your management team?