Across all types of investments, return on investment (ROI) is more common than internal rate of return (IRR), largely because IRR is more confusing and difficult to calculate.
The IRR of a potential investment is the discount rate or rate of return that you’re getting from an investment when you consider the initial cash outlay against the timing and size of future cash flows.
It's the rate of return of an investment where external factors, such as inflation or the cost of capital, aren't considered. Simply stated, the IRR for an investment is the percentage rate earned on each dollar invested for each period it is invested.
A good time to utilize IRR is when you're trying to decide if an investment provides a high enough return.
IRR is also useful in demonstrating the power of compounding. For example, if you invest $50 every month in the stock market over a 10-year period, that money would turn into $7,764 at the end of the 10 years with a 5% IRR.
Using IRR to obtain net present value (NPV) is known as the discounted cash flow method of financial analysis. NPV is always an amount, and IRR is always a percentage that reflects the interest yield from the investment.
NPV considers all projected cash inflows and outflows and employs a concept known as the time value of money to determine whether a particular investment is likely to generate gains or losses.
ROI, on the other hand, tells an investor about the total growth, start to finish, of the investment. It is not an annual rate of return. IRR tells the investor what the annual growth rate is. The two numbers normally would be the same over the course of one year but won’t be the same for longer periods of time.
One of the disadvantages of using IRR is that all cash flows are assumed to be reinvested at the same discount rate, although in the real world these rates will fluctuate, particularly with longer-term projects. IRR can be useful, however, when comparing projects of equal risk, rather than as a fixed return projection.
While IRR takes into account the passage of time, ROI does not. A stock's ROI can remain the same regardless of how much time passes between purchase and sale.
Life insurance has a very high IRR in the early years of policy—often more than 1,000%. It then decreases over time. This IRR is very high during the early days of the policy because if you made only one monthly premium payment and then suddenly died, your beneficiaries would still get a lump sum benefit.
To calculate IRR, you can use an IRR calculator, a spreadsheet, but working with your accountant is advisable.
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